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My dividends and capital gains are now a large enough percentage of my total annual income to be a tax burden and require advance tax planning, so what's the best way to pay the additional tax due:

a) Change a small portion of my "dividends and capital gains" from "re-invest" to "distribute", then just use some of those proceeds to pay the tax (in estimated tax payments), or

b) Increase the withholding tax on my employer's W-4, to have the tax taken directly out of my salary, or

c) Something else?

The problem with "b" is that it would place a much lower limit on my monthly cash flow (monthly budget). With "a", I'll be starting to use some of these investment gains to pay the tax bill, while simultaneously maintaining my monthly cash flow...Maybe it's time to start using the gains, in this manner. "a" is making much more sense to me now...

Thoughts??

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    money is fungible. Why do you see a difference between (a) and (b)?
    – littleadv
    Commented Feb 25, 2023 at 7:51
  • @littleadv organizationally they’re different.
    – RonJohn
    Commented Feb 25, 2023 at 10:31
  • Not the question you asked, but I would start by taking a hard look at tax efficiency of your investments. What is it that you hold in your taxable account that is throwing off this kind of distributions? Can you swap it around with your tax-advantaged accounts? Are you maxing out your tax-advantaged contributions? Total stock market has around 1.5% distribution yield. It would take a fairly sizable taxable investment for the distributions tax drag to become an issue.
    – void_ptr
    Commented Feb 27, 2023 at 6:17
  • Yes, I have been maxing out 401(k), HSA, and Roth IRA for the past several years. Last year I even started post-tax 401(k) contributions - all to try to "hide" as much money from taxation as I could. But now that I have all these growing "tax-exposed" investments(standard stock and bond index mutual funds, including REITs), I don't know how to shift them to investments that don't lead to dividends i.e. taxation.
    – j03y_
    Commented Feb 28, 2023 at 7:10

3 Answers 3

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(a) means having to file estimated taxes.

(b) requires you to funnel the distributions into your checking account to replace the extra W-4 withholding.

Neither is “better”; you must choose which is more convenient/practical for you.

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RonJohn has already answered, but I will add one caveat re your option (b). If many of your dividends and capital gains are from investments in mutual funds, then be aware that most mutual funds declare and distribute dividends and capital gains in December and so there might not be a sufficient number of paychecks on which you can adjust withholding to cover the tax due. Some amelioration of this dilemma is possible if you use the numbers from the estimates of year-end distributions that many mutual fund houses publish on their websites in November, and also (less commonly) if your employer pays year-end bonuses (often on December 31) and asks what percentage of the bonus should be withheld as tax.

If your dividends and capital gains are large enough, and mostly from mutual funds, I would suggest that option (a) is a better choice if you are willing to file the long version of Form 2210 (Underpayment of Estimated Taxes) with your income tax return which will show the taxable income thus far for the four quarterly payments of estimated tax, and prove that you don't owe a penalty for underpayment of estimated tax; you have been having sufficient withholding for the first three quarters to cover the estimated tax payment due, and it is only the last quarter when you had all this extra income and for which you are making fourth quarterly payment of estimated tax by January 15. The short version of Form 2210 (which is what the IRS uses if you ask the IRS to compute the penalty for underpayment) will indicate that you do owe a penalty; the long version delves into the details and shows that you don't.

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c) Something else?

Well it is almost your option B. The fundamental problem with option B is that if you get hit with a large dividend or capital gain in December you may not be able to adjust your withholding.

If the goal is to be able to avoid having to pay a penalty for underpayment or under-withholding, then adjust your W-4 to make the safe harbor.

General Rule

In most cases, you must pay estimated tax for 2023 if both of the following apply.

  1. You expect to owe at least $1,000 in tax for 2023 after subtracting your withholding and tax credits.

  2. You expect your withholding and tax credits to be less than the smaller of:

  • 90% of the tax to be shown on your 2023 tax return, or

  • 100% of the tax shown on your 2022 tax return. Your 2022 tax return must cover all 12 months.

Note. The percentages in (2a) or (2b) just listed may be different if you are a farmer, fisherman, or higher income taxpayer. See Special Rules, later.

Higher Income Taxpayers

If your AGI for 2022 was more than $150,000 ($75,000 if your filing status for 2023 is married filing a separate return), substitute 110% for 100% in (2b) under General Rule, earlier.

For 2022, AGI is the amount shown on Form 1040 or 1040-SR, line 11.

What this means is that when you file this spring you look at what your taxes were for 2022. Then make sure your withholding in 2023 is 100% (under $150K AGI) or 110% (greater than $150K AGI) of your 2022 taxes. If you get hit with a large dividend or capital gain late in the year, this avoids the penalty. This is even true if you have to write a big check in April 2024. I did this when I sold rental property a number of years ago. I had to write a check to the IRS the next spring, but there was no penalty.

My employer allows us to file the W-4 electronically and the change takes place the next paycheck.

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  • This is what I've almost always done.
    – Barmar
    Commented Feb 25, 2023 at 23:51
  • Thanks so much to everyone who has commented and viewed my post thus far. Just FYI - I'm talking about standard mutual fund dividends and capital gains, which appear to be distributed monthly and/or quarterly (dividends, including late December for Q4), and mostly in Sept/Oct/Dec (cap gains). I'll plan to change some of my dividends from "re-invest" to "distribute" (my option "a") and then use that money to pay the estimated tax payments throughout the year, instead of requesting additional withholding (my option "b") which would severely reduce my monthly cashflow (and lifestyle).
    – j03y_
    Commented Feb 26, 2023 at 18:20
  • @j03y_ You could instead increase your withholdings, and use distributions to cover your cash needs. This has the advantage of withholdings always being considered timely (not true for estimated payments). Money is fungible, as others have already said.
    – void_ptr
    Commented Feb 27, 2023 at 6:23

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