Planning your tax payment strategy

Helping clients put a solid plan in place for paying their tax liability can make the annual tax process less painful for many.

The filing period for 2023 tax returns is in full swing, and the most eager filers may have already received their tax refund. If your client likes the idea of getting that refund each year – perhaps they view it as kind of a surprise bonus – you’ll want to remind them that a refund is really an interest-free loan to the government. With savings accounts paying a meaningful interest rate these days, they might be better off having control of their money sooner.

Conversely, your clients who owe money this year may be waiting until the last possible moment to file to earn an extra bit of interest on their savings. But owing too much may mean being assessed an underpayment penalty, and with the IRS interest rate on underpayments currently at 8 percent annually, it’s a cost they would do best to avoid.

Regardless of which camp your clients are in for 2023, this is the perfect time of year to help them think through a better tax payment strategy for 2024.

YOUR REQUIRED ANNUAL PAYMENT

The IRS offers taxpayers a way to maximize their payment deferral while avoiding a penalty by simply paying what it refers to as the “required annual payment.” And, even better, there are options for how to do that, neither of which requires the full tax liability to be paid until the tax return is due.

Some taxpayers may choose the more certain option of paying 100 percent of what their total liability was for 2023 in 2024. For those whose adjusted gross income in 2023 exceeded $150,000, this target increases to 110 percent. This strategy, referred to as the “safe basis” method, can be ideal for those whose tax cost in 2024 is expected to be higher than it was in 2023. This would include taxpayers whose income may spike this year due to a large capital gain, Roth conversion, stock option exercise, business sale, or other unusual event. That additional tax caused by the event doesn’t have to be paid right away as long as taxpayers follow the safe basis rules.

Those whose 2024 tax liability will be the same as, or even lower than, 2023 may prefer option two – targeting their payments to be at least 90 percent of this year’s actual liability. This requires making an accurate forecast of their 2024 tax liability and perhaps aiming a bit higher than 90 percent to provide some cushion.

Either scenario will leave them owing some tax when they file their return, so be sure to help them plan for that payment. Whatever they owe at that point must be paid by the due date of their return, typically April 15. And while an extension can be requested to delay filing their return, that extension doesn’t apply to making that final tax payment.

HOW TO MAKE THE TAX PAYMENTS

As for how that required annual payment is actually paid, most people have options. Wages from an employer are subject to mandatory withholding, making the payment process simple – the employer calculates what the employee must withhold and sends it to the IRS on their behalf. Employees don’t have much ability to lower that amount these days, with the idea of “allowances” having gone the way of VHS tapes. For an employee with no other additional income, withholding is often more than their actual tax liability, meaning a future tax refund is an unavoidable outcome.

Withholding can also be taken from most forms of retirement income, such as IRA or 401(k) withdrawals, pension payments, and even Social Security benefits. You can help your clients choose a specific percentage to withhold, allowing them to carefully manage their payments.

Other sources of income – such as business or investment income – require more planning, as withholding isn’t normally an option on those. This can also be true for Roth conversion income. Paying those taxes from other sources, rather than withholding on the conversion amount, makes for a more effective conversion. This is where making quarterly estimated payments comes in.

Estimated payments can be made old-school style by mailing a check to the IRS. For those clients who opt to mail a payment, remind them to include Form 1040-ES so the payment is properly credited to them. The IRS also offers an online payment system that allows taxpayers to set an exact date on which their account will be electronically debited. While the idea of the IRS directly debiting an account may seem a bit scary, it’s really the most reliable way to ensure payments are made on time.

DIY taxpayers who use one of the popular software tools to prepare their return should be cautioned about the automatic recommendations those tools have been known to make. For example, if your client ends up owing something when they file their 2023 return, those programs may automatically generate estimated payment vouchers for 2024. The program assumes they want to hit the safe basis target for 2024 and that their withholding will be the same as it was 2023, so they generate a payment voucher to make up the difference. None of those assumptions may be correct, so it pays to assist clients in reviewing those recommendations before automatically following them.

While no one will ever look forward to paying their taxes, helping clients put a solid strategy in place that maximizes control and minimizes expense can at least make the process less painful.

Tim Steffen is director of advanced planning for Baird. Follow him on Twitter @TimSteffenCPA.