Today, I’m kicking off my annual “Taxes from A to Z” series. As part of the series, I plan to focus on tax terms that might not get much play on a day to day basis… If you’re wondering what the heck MAGI is or how to figure out the difference between an injured spouse and an innocent spouse, this is one series you won’t want to miss.
A is for Annualized Income Installment Method.
Taxpayers who report income not subject to withholding, or if the amount of income tax which is withheld isn’t enough, are required to make estimated tax payments. Income not subject to withholding includes income from self-employment, interest, dividends, prizes, and gains from sales – typically income that you would find reported on one of the forms 1099. Income that appears on other schedules or which might not be reported on a form 1099, such as alimony and some rents, may also affect your estimated payments due. You may also have to pay estimated tax if the amount of income tax being withheld from your salary, pension, or other income is not enough.
You make estimated payments throughout the year in equal, quarterly installments: April 15, June 15, September 15, and January 15 of the next calendar year. This is the equivalent of your withholding had you worked for a wage. If you don’t pay enough estimated tax or if you don’t make your estimated payments on time, you may be subject to a penalty. You can generally avoid the penalty if you pay at least 90% of the tax for the current year or 100% of the tax for the prior year (whichever is smaller).
All of that said, the Internal Revenue Service (IRS) does realize that not all taxpayers are created equal. Sometimes income isn’t paid out evenly especially, for example, if you’re a seasonal worker. If you didn’t receive your income in equal installments throughout the year, you may be able to lower or eliminate your estimated tax penalty by figuring your underpayment using the annualized income installment method.
The annualized income installment method is exactly like it sounds on the tin: it allows taxpayers to annualize tax for each period based on an estimate of income and deductions rather than in equal installments. In other words, if your estimated tax liability is $20,000 for the year, but $15,000 of it is attributable to the one quarter, the IRS allows you to figure the liability as income accumulated throughout the year. So instead of simply dividing the tax due by four and paying $5,000 per quarter (especially if you don’t have that $5,000 because you haven’t earned it yet), you can use the annualized income installment method to figure out how much to pay as you go.
To use the annualized income installment method, you complete a worksheet at the end of each payment period and figure the payment due. You’ll also file a federal form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, including Schedule AI (downloads as a pdf) with your individual federal income tax return.
There is a downside. Because the penalty is figured separately for each period, you could owe a penalty for an earlier payment period even if you make it up later. This is true even if you are due a refund when you file your income tax return. So plan carefully. While this method can be easier on your pocketbook, it’s more time consuming and there is increased potential for making a mistake. If you’re not sure how to calculate the tax due, it’s best to use a tax professional.
