19

It looks like the tax investment penalty is about 2.6%, which makes me wonder why anyone pays quarterly estimated taxes. Wouldn't you be better off putting that money into stocks and using the proceeds to pay the penalty? Obviously some people have cash flow issues and in some years stocks lose value, but assuming you're planning long term, doesn't paying all your taxes in the next year make more sense?

source: https://www.irs.gov/taxtopics/tc300/tc306

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    What country? In the US the penalty and interest for unpaid taxes is much higher than 2.6%. – D Stanley Oct 25 '17 at 15:31
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    You can't compare to a risky rate of return - you should compare to a risk-free rate of return [ie: a money market fund which would otherwise earn you 1%]. There is 0 risk that the IRS chooses not to collect its penalty, and therefore it must be attributed a risk-free rate. [Technically there is a 'risk' that you for example lose your job in September, and therefore earn far less than you expected, and therefore you can "over-prep-pay" your taxes, but I don't think this risk is anywhere close to the risk of, for example, a mutual fund underperforming]. – Grade 'Eh' Bacon Oct 25 '17 at 15:51
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    In addition to the purely financial penalties & interest, there's also the possibility that you might attract unwanted attention, increasing your risk of having your returns audited.. It;s the nail that sticks up that gets hammered down – jamesqf Oct 25 '17 at 17:50
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    @HartCO+ yes the rate was 4% for 2016; it will change in future if short-term (<=3yr) Treasury rates return to historical norms. Your required payment (usually 90% of tax) is by default owed in four quarters as of April 15, June 15, Sep. 15, and Jan. 15, and 4% on the balances from those dates to April 15 adds up to 2.658%. If you make unequal or untimely payments, or use schedule AI to differently allocate the amount owed, you compute a 4% rate on the actual balances using the worksheet in form 2210 instructions. – dave_thompson_085 Oct 25 '17 at 20:00
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    @WhirlMind: It's not payment of tax in advance, it's payment as the money is earned, at the expected effective rate. Done this way, government income is fairly steady, without a huge need for short-term borrowing to cover all expenditures between payment due dates. – Phil Miller Oct 26 '17 at 16:22
31

Same argument and answer for investing instead of paying off debt, or borrowing to invest. Risk. What happens if the stocks drop by 10%? Sure, you might come out ahead on average, but a drop in the market could be catastrophic from a cash flow point of view.

In addition, federal tax debt is arguably the worst kind. The IRS has the authority to garnish wages and has virtually unlimited resources they can use to collect.

  • 1
    Student loan debt is pretty obviously worse than federal tax debt. Assuming you're not actively trying to avoid paying, I would say federal tax debt is one of the best kinds of debt. It's low interest rate, and the collector is generally accommodating when it comes to making plans for payment as long as you're making an effort to pay rather than to get out of paying. – R.. Oct 25 '17 at 19:07
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    As someone formerly in the Student Loan industry, the debt for student loans is much easier to pay off, and in fact can be written off in many cases under and income contingent payment plan. – Anoplexian Oct 25 '17 at 21:03
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    Mind you that the first time you have underpayment, there is no penalty, only if you keep doing it. So you might consider that as long as historically you have been on track and penalty free, to avoid paying taxes in advance until such time that your circumstances change so much that you end up under the for the first time, and THEN you might consider paying some in advance to avoid another under year and potentially penalty. Otherwise, there is little reason to advance pay taxes, unless you have nothing better to use the funds for. Just a thought. – GµårÐïåñ Oct 25 '17 at 21:12
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    The fees and penalties for not making estimated tax payments are pretty small and it's often perfectly reasonable to just not make those payments if you have something better to do with the money. Just make sure you can make the actual tax payment when it's due because the penalties and interest shoot up pretty drastically at that point. – David Schwartz Oct 25 '17 at 23:10
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    @GµårÐïåñ: there is no exception to underpayment penalty just because it's the first time. But if your tax increases one year, perhaps unexpectedly (there are other Qs with cases), and you withhold-or-prepay the amount of the previous year's tax (or 110% if AGI over $150k), there is no penalty -- so if you owed no tax for the previous year there is no penalty even if you don't prepay. If your tax continues higher for multiple years, this doesn't help on the subsequent years. – dave_thompson_085 Oct 26 '17 at 13:16
6

Your logic is not wrong. But the risk is more significant than you seem to assume. Essentially you are proposing taking a 2.6% loan to buy stocks.

Is that a good strategy? On average, probably. But if your stocks crash you might have significant liabilities.

In 1929, the Dow Jones dropped 89%. In 1989, >30%. In 2008-9, 54%. This is a huge risk if this is money that you owe in taxes. If you operate the same system year after year the chance of it going horribly wrong increases.

  • 2
    I agree if you're talking about only investing the amount you will owe in taxes, but I'm guessing that OP is proposing just adding your owed tax money to other, much larger existing investment accounts, then withdrawing the needed portion later. I feel that this would mitigate the risk significantly, although in a down year you will still pay a premium for needing to take out the money at tax time. – Wesley Marshall Oct 25 '17 at 15:39
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    The key that I think the OP missed is just how bad a 'down year' can be. Plenty of people who thought they had more than enough have lost everything in crashes with leveraged investments. It could work for sure, but the potential downsides are not limited to those with "cash flow issues". – Mark Perryman Oct 25 '17 at 15:51
0

In addition to the other answers, which cover the risks of what is essentially leveraged investing, I'd like to point out that the 2.6% penalty is a flat rate. If you are responsible for withholding your own taxes then you are paying tax four times a year. So any underpayment on your first quarterly tax payment will have much more time to accrue in the stock market than your last payment, although each underpayment will be penalized by the 2.6%. It may make sense for someone to make full payments on later payments but underpay on earlier ones.

  • Actually the ~2.6% on 2016 Form 2210 is a 4% rate applied to a balance accumulating at the four quarters used by the IRC, see my comment to @HartCO on the Q. – dave_thompson_085 Oct 25 '17 at 20:14
  • Yes you are right, it is only a flat rate if you use the "short method" on the form. The "regular method" lower down does what you say. – Nosrac Oct 26 '17 at 12:31
-1

"While the US tax code does not directly impose an obligation to pay estimated taxes, it does impose a penalty on individuals for failure to pay enough taxes either through withholding or estimated tax." USMTG

Anyone can choose how s/he wants to pay their taxes but they better deal with any consequences of not paying them instead of just complaining about it like most people do.

Most people get the hatred towards the IRS but most complaints are misdirected and should be directed towards Congress who creates and messes around with the US Tax Code.

Some people actually do not make estimated payments and pay any possible taxes with their returns knowing that there may be underpayment penalty. For those people, the penalty is relatively small compared to what they can do with the cash over a year's time (i.e. investing or paying down debt). It's their choice!

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    This reads more like a rant against those who complain about paying taxes. Your 5th paragraph is the only one that comes close to answering the question. – Nosrac Oct 25 '17 at 15:52
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    It may be a rant, but you can downvote the answer. Answering with a strong opinion doesn't qualify for a flag. – Nathan L Oct 25 '17 at 16:07
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    @Nathan L: I'm not concerned about whether this post is strongly opinionated, I'm concerned about whether this answers the question. The question asks "does it make sense to delay payment of taxes?" and this answer's relevant content says "some people do delay paying taxes". – Nosrac Oct 25 '17 at 17:02
  • Does it make sense to delay payment of taxes? That is entirely a "subjective Choice" which is the point. At least people should be informed of why estimated tax should/not be made then let them make their choice. Isn't that the reason for the forums? – MrMojo Oct 25 '17 at 17:04
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    It is true that there is no right answer, though a useful answer in this case would inform others about the benefits and disadvantages of delaying taxes so that they can make a choice. This answer adds nothing not already covered by other answers. – Nosrac Oct 25 '17 at 17:17

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