As year-end approaches, it is a good time to review your 2019 income tax withholdings and assess your exposure to estimated tax penalties. Individuals with significant income in addition to their salaries may find themselves subject to estimated tax penalties if they don’t increase their tax withholdings in 2019. Other individuals may be over-withheld and want to reduce their withholdings this year, rather than wait till 2020 for their refund.
Planning for 2019 taxes takes place in the shadow of the changes made by the Tax Cuts and Jobs Act (Act) that included lower income tax rates, an increased standard deduction, limited itemized deductions and lost personal exemptions, among other things. With these changes, many individuals found themselves in unfamiliar circumstances when filing their 2018 returns. Some who were accustomed to large overpayments in prior year returns found themselves with small refunds or owing tax. Others were surprised to have large overpayments of tax. Unless individuals had worked with advisors to consider planning alternatives and project 2018 tax liabilities in anticipation of the Act’s changes, the results were often unpredictable.
Tax Reform is still having a huge impact.
Start Year-End Tax Planning BEFORE Year-End
By planning in advance of year-end, projecting your expected taxes due and adjusting your withholdings or estimated tax payments, you can protect against having unexpected tax results or being subject to penalties. For 2019, individuals generally will be subject to penalties if their tax withholding and/or quarterly estimated tax payments do not equal or exceed the smaller of 90% of the tax shown on their 2019 returns or 100% of the tax shown on their 2018 returns (this threshold increases to 110% for individuals with 2018 adjusted gross income over $150,000.)
For 2018, the IRS waived underpayment penalties in many cases due to the difficulties posed by the Act’s changes. However, there is no indication that the IRS will soften the withholding/estimated tax payment requirements for 2019 returns. Keep in mind states may have their own tax withholding and estimated tax requirements.
For those that like to “do-it-yourself,” the IRS provides a Tax Withholding Estimator for projecting your federal income tax liability and determining whether you may need to adjust your income tax withholdings. Individuals who are employed can adjust their withholdings by giving their employers a new Form W-4, Employee’s Withholding Allowance Certificate. Retirees receiving retirement plan distributions can use Form W-4P, Withholding Certificate for Pension or Annuity Payments, and submit it to the payer.
In addition to reviewing 2019 tax withholding levels, you may also want to tentatively calculate your targeted 2020 withholdings. Changes to withholding allowances made in 2019 will carry over to 2020, so they may need adjustment early next year.
What To Do if Your Withholdings Are Too Low
If you determine your 2019 income tax withholdings are not enough to protect you from IRS penalties, you can reduce your exposure to the penalty by making estimated tax payments directly to the IRS. However, it may be difficult to eliminate the penalty with tax payments this late in the year.
A better approach may be to adjust your income tax withholdings. Income taxes withheld by an employer are treated as having been paid in equal amounts throughout the tax year. Consequently, if your employer withholds adequate additional amounts over the rest of 2019, the penalty may be retroactively eliminated.
This same strategy generally can work for tax withholdings on retirement plan distributions. In fact, if your withholdings are significantly short of the amount needed to avoid an estimated tax penalty, consider taking a distribution from your qualified retirement plan this year, subject to tax withholdings, then timely rolling over the full amount of the distribution into a traditional IRA—within the 60-day rollover period. These withholdings will be treated as paid in throughout 2019, but the distribution—to the extent it is rolled over—will be excluded from taxable income. These rules can be complex, so seek the advice of a qualified professional advisor. And, if you’re still too low on estimated payments, a retirement distribution can be totally applied to federal tax and considered as paid throughout 2019.
Planning is the Key to Year-End Success
In addition to adjusting tax withholdings and making estimated tax payments, there are also steps to consider before year-end to reduce tax liabilities—both federal and state. Despite the changes brought about by the Act, the time-tested tactics of deferring income and accelerating (or “bunching”) deductible expenses still work for many individuals.
Want to learn more about common tax planning strategies? Download our guide.2019-2020 Tax Planning Guide
For assistance projecting your federal and state tax liabilities, reviewing the adequacy of your tax withholdings and estimated tax payments and considering prudent tax planning techniques, please contact your Eide Bailly professional.
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