648 / Must a taxpayer make estimated tax payments and what is the penalty for failure to make a required installment payment?

Taxpayers are generally required to pay estimated tax if failure to pay would result in an underpayment (see below) of federal income tax for the current taxable year.¹ The computation of estimated tax for the tax year includes the alternative minimum tax, additional Medicare tax, net investment income tax, and self-employment tax (see Q 777 and Q 784, respectively).² An underpayment is the amount by which a required installment payment exceeds the amount, if any, paid on or before the due date of that installment (due dates are April 15, June 15, September 15 of the current tax year and January 15 of the following tax year).³ The required amount for each installment is 25 percent of the required annual payment.⁴

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Planning Point: The IRS took the opportunity to remind taxpayers in 2020 that unemployment compensation benefits are subject to federal income tax. This included expanded unemployment benefits created by the 2020 CARES Act. However, the IRS reminded taxpayers that withholding is completely optional. Taxpayers can elect to have a flat 10 percent withheld and paid over automatically to the IRS by submitting Form W-4V, Voluntary Withholding Request, to the agency paying the benefits. Taxpayers should not send this form to the IRS.

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Taxpayers also have the option of making quarterly estimated tax payments under the usual rules to cover their anticipated tax liability.

Generally, the “required annual payment” is the lesser of (a) 90 percent of the tax shown on the return for the taxable year (or, if no return is filed, 90 percent of the tax for the year), or (b) 100 percent of the tax shown on the return for the preceding year (but only if the preceding taxable year consisted of 12 months and a return was filed for that year).⁵ However, if an individual’s adjusted gross income for the previous tax year exceeded $150,000 ($75,000 in the case of married individuals filing separately), the required annual payment is the lesser of (a) 90 percent of the current year’s tax, as described above, or (b) the applicable percentage of the tax shown on the return for the preceding year (110 percent).⁶

On the other hand, the taxpayer may make required installments pursuant to the “annualized income installment” method if the amount of tax so computed is less than the tax computed pursuant to the two alternatives described above. This method requires the taxpayer to compute the tax for the current year by annualizing the taxable income, alternative minimum taxable income and adjusted self-employment income for the months in the taxable year ending before the due date of the installment. For the first quarter installment payment, the taxpayer must pay
22.5 percent of the annualized tax. For the second quarter installment payment, the taxpayer must pay 45 percent of the annualized tax less the amount of tax paid with the first installment. For the third and fourth installment payments, the taxpayer must pay 67.5 percent and 90 percent, respectively minus the aggregate amount of tax paid with the prior installments.⁷

Regardless of the method used to calculate estimated taxes, there is no penalty for failure to make estimated payments if: (1) the tax shown on the return for the taxable year (or, if no return is filed, the tax) after the deduction for tax withholdings is less than $1,000; or (2) the taxpayer owed no tax for the preceding year (a taxable year consisting of 12 months) and the taxpayer was a U.S. citizen or resident for the entire taxable year.⁸ Otherwise, underpayment results in imposition of an interest penalty, compounded daily, at an annual rate three percentage points greater than the short-term applicable federal rate as adjusted quarterly.⁹ (See Q 676.)

If on the Form 1040 for the current year, the taxpayer elects to apply an overpayment to the succeeding year’s estimated taxes, the overpayment is treated as a credit with respect to installments of estimated tax due on or after the date(s) the overpayment arose in the order in which they become due. Depending on the amount of the overpayment, it may be sufficient to avoid or minimize the penalty for failure to pay estimated income tax with respect to such tax year.¹⁰ For application of the estimated tax to trusts and estates, see Q 795.