Estimates aren't just a quarterly pain...

Taxes hurt. The more you make, the more you pay. Sometimes it may even seem like you’re being punished for success. You’re not, of course, but that doesn't make it hurt any less. To top it off, at the end of the year, there’s always a mad scramble to come up with the money to pay the extra amount of taxes that weren’t covered by your employer withholding.


But what happens when the tax bill is due to something other than insufficient withholding? As I am wont to do, I was reading through Accounting Today (terrific publication) and came across an article entitled, “‘I put faith in these guys’: Vanguard clients decry tax debacle”. The gist of the article is that Vanguard, a popular investment firm, made changes to a target-date fund. These changes caused investors to pull money out of other funds and invest in the adjusted one. The result was huge capital gains. And where there are gains, there are taxes.


The article gives a few examples of this:

“Valerie Verduce of Georgia, [sic] held Vanguard’s 2020, 2030 and 2040 retail funds in taxable accounts. Those products distributed more than $60,000 in capital gains last year, leaving her with an estimated $9,000 tax liability. Another, Anthony Pollock of California, invested in Vanguard’s 2025 and 2035 retail funds and saw the holdings distribute more than $105,000 in capital gains, leaving an estimated $36,000 in tax liabilities. Catherine Day of Massachusetts invested in the 2025 and 2030 retail funds, which distributed more than $80,000 of capital gains, resulting in an estimated $12,000 tax liability”


Every one of these people (who, by the way, are now suing Vanguard), chose to invest in these funds with the hope that they’d make money – you generally don’t invest with the hope of losing it, after all. Those hopes have paid off. At this point, I’m going to veer off the subject of the article (yes, I know the article is more about how the gains were made, but that’s not what I’m discussing).


Imagine you are Valarie, Anthony, or Catherine and have just received a LARGE distribution from Vanguard. What do you do? Put the money in a bank for a rainy day? Take the family on Vacation? By a new Ferrari? Maybe even reinvest into something else? Those are all options (and if you’re looking to buying a Ferrari, don’t buy a red one. Police are far more likely to give you a ticket if you do). But before any of those, you should look to make an estimated payment first.

Estimates are, well, exactly what the name implies, an estimate of the taxes you will owe. IRS publication 505 says, “You may have to pay estimated tax if you receive income such as dividends, interest, capital gains, rents, and royalties. Estimated tax is used to pay not only income tax, but other taxes such as self-employment tax and alternative minimum tax.”


But how do you do that? Option 1: try it on your own. Pub 505 has all the charts and instructions you technically need to file and pay your estimated tax. Its also confusing, frustrating, and irritating. Option 2: have your tax professional work on it for you. Option 2 is definitely easier, but it’s your choice. 


But what happens if you don’t make this estimated payment? Well, for starters, you’re going to have to pay the tax anyway (look at the examples above to see how much they’re going to be paying). On top of that, you may be subject to a penalty for Underpayment of Estimated Tax. The IRS website on underpayment says, “The United States income tax system is a pay-as-you-go tax system, which means that you must pay income tax as you earn or receive your income during the year. You can do this either through withholding or by making estimated tax payments. If you didn't pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.”


Taxes are a sometimes-painful reminder that all we earn is not ours to keep. But just because they are painful, doesn’t mean you should put it off until the very last second. There’s an old saying my mother used to quote. How do you eat an elephant? One bite at a time. How should you pay that tax bill? Before it becomes due, one small payment at a time.