Who Needs to Pay Estimated Taxes?
June 15th is just around the corner… and if that date doesn’t ring a bell, we think it’s a good idea to keep reading.
So what is June 15th?
It’s a crucial date to remember for those who need to pay estimated taxes throughout the year. Timing for quarterly estimated payments is a little different than you might expect. It’s not 15 days following each quarter end, but instead, estimated tax payments are due April 15th, June 15th, September 15th, and January 15th each year. Recently, we noticed that many of our clients were surprised by how much they owed during tax time for tax year 2021. If you’re in this boat - earning stock compensation as a large portion of your income, working for yourself, or have significant side-hustle income - this blog post is for you.
Let’s zoom out and talk about taxes
Taxes must be paid as you earn or receive income throughout the year. Workers can do this in two different ways:
Through withholding. The amount your employer withholds is decided after they receive your completed W4 when you start your job.
Through estimated tax payments. As we mentioned earlier, estimated tax payments for individuals are due on April 15th, June 15th, September 15th and January 15th of the following year. Below is a schedule from Kipplinger for the due dates for 2022 estimated payments.
Calculating the taxes you owe for the current year is a complicated formula, involving deductions, credits, and a progressive tax system, whereby the percentage of tax we pay goes up as our income goes up. If you’re a business owner, your business structure and how you pay yourself will add additional complexities. This is why we always recommend our clients utilize a tax professional to help them accurately calculate and pay their taxes. However, as financial planners, there are also some tools we use to determine if clients are at risk for owing a tax penalty for underpaying their taxes throughout the year.
After the passing of the Tax Cuts of Jobs Act, we found that many more American workers owed taxes and subsequent penalties for under-payment come tax time. At Mana, we don’t want our clients forking over money unnecessarily, so today we’re going to focus on the estimated tax payments.
How could you know if you need to pay estimated taxes?
All taxpayers earning more than $150k per year are required to pay either 90% of their current year tax liability, or 110% of their prior year tax liability to avoid a penalty. The timing of these payments is also important with respect to avoiding penalties. Withholding from a paycheck or retirement account distributions are considered to have happened throughout the year, but estimated tax payments should be timed to correspond with the timing of the income earned. The penalty doesn't apply if you owe less than $1,000 in tax.
To get into more details, we’ll break up this conversation into three archetypes; an individual who is earning…
W2 income, all cash compensation (e.g. a salary, bonus, and commissions)
W2 income, with a combination of cash and stock compensation
Additional income, such as self employment, dividends, interest, capital gains, or real estate income.
W2, all cash compensation
One of the greatest benefits of working W2 employment with all cash compensation is that this tends to be the simplest from a tax perspective. Salaried income taxes are withheld based on the output of your W4. Someone who selects Single with no dependents will pay more tax through withholdings than someone who selected Married with 2 dependents, as an example. This is because taxes for a single person are higher than someone who is married filing jointly, for the same level of income. Similarly, someone who files with 2 dependents would likely receive tax credits for having two dependents, in which case they would need to contribute less to taxes through their paycheck. However, just because you filled out your W4 correctly, doesn’t always mean you’re paying enough in taxes. If the amount withheld is less than what is owed, you may need to adjust the withholdings or pay quarterly estimated taxes to make up the difference.
If this is your situation, you’ll need two key documents to determine if you’re on pace for this year: last year’s tax return, and your most recent pay stub.
Test #1 - Check if you met the safe harbor requirements based on last year’s tax return
Last year’s tax return will show the total amount of taxes paid. Multiplying this number by 1.1 (or 110%) will show you how much you would need to pay in taxes to meet the safe harbor requirements (or the amount needed) to avoid penalties for this year. Compare this to how much you expect to pay in taxes by reviewing your pay stub. For June 15th, you will owe taxes on all income through May 31st, If your pay stub is dated May 31st and you earn income evenly throughout the year, divide your year-to-date taxes paid by 5 to get a monthly taxes paid, and multiply it by 12 to get an estimate of the amount you’ll pay for the full year. Alternatively, you could see the amount you withheld during the current month and multiply by 12, or the amount you withheld during the pay period and multiply by 24 or 26, depending on the number of pay periods. If you receive bonuses, this math gets a little more complicated, so we’d recommend comparing how much you earned so far this year by the amount you expect to earn for the full year, and running a similar calculation. No matter how you get to your estimate, if you aren’t paying 110% of last year, it is likely you owe estimated payments using this test.
Test #2 - Checking if you are paying enough to cover 90% of this year’s tax liability
Even if you don’t meet the safe harbor requirement of 110% of last year, you can avoid a penalty if you are paying enough in tax to cover 90% of this year’s tax liability. If your income hasn’t significantly changed since last year, there are two spot checks you can do to evaluate if you’re paying enough in tax. Again, you’ll need to start with your tax return from last year.
A quick checklist:
Did you owe taxes last year, or did you receive a refund?
Did you change jobs, have any significant life changes that might increase your tax bracket (e.g. marriage, divorce, kids graduating from college)?
Did you change your W4?
If you received a refund, had no major life events, and didn’t change your W4, it’s probably safe to assume you are withholding enough in taxes through your pay stub. If you owed taxes last year, changed jobs, had any significant life changes, or changed your W4, you might want to take it a step further:
Start by reviewing your tax return, and determine your effective (or average) tax rate by dividing your total tax by your taxable income. Then grab your most recent pay stub. You’ll want to compare your effective tax rate on your prior year return to the rate currently being withheld from your pay stub. Divide the amount of year-to-date taxes withheld for federal taxes by your gross income with pre-tax deductions subtracted. If the percentage being withheld is greater than 90% of your effective tax rate last year, and your income hasn’t significantly changed, you’re likely in good shape.
Remember, you either have to pay 110% of last year OR 90% of this year’s taxes due, so only one of the two tests above needs to work in order to avoid a penalty.
W2, cash and stock compensation
The analysis process is similar, but stock compensation always adds complexity to the mix. We’ll highlight two types of stock compensation to let you know how to think about the need to make estimated taxes. We’ve also included links to some additional resources in this section, in case you’re wondering what any of this lingo means.
Because stock compensation is income on top of your normal cash compensation, you’ll want to consider your marginal tax rate, versus your average tax rate. The marginal tax rate is the highest tax you pay, sometimes referred to as your tax bracket. If you know approximately how much you will earn during the year, including cash, bonuses, commissions, stock compensation, and any other income, you can find your tax bracket, or marginal tax rate for 2022 here.
RSUs: Restricted stock units are essentially cash bonuses that you use to invest in your company’s stock. When your RSUs vest, they should show up on your pay stub. Companies are required to withhold at supplemental tax withholding rates of 22% for federal taxes, so long as your supplemental earnings are below $1 million. If you are in the 24%, 32%, 35%, or 37% tax bracket and you haven’t requested to increase your withholding, this means that all of your RSUs that vest are being underwithheld. For example, if you are in the 35% tax bracket, and you have $100k of RSUs that have vested this year through May 31st, your company will have withheld $22k for federal taxes through payroll deductions. However, you actually owe $35k, so this means you owe a balance of $13k. This can be paid through estimated taxes. For more details, check out our blog: I Have Rsus, But Didn’t Sell Any. Why Is My Tax Bill So Crazy?
Stock Options: There are no tax implications when your stock options vest, however, as soon as you exercise your stock options, you will be responsible for paying tax. As you might have guessed, these are complicated calculations! Most importantly, if the exercise price you pay is lower than the current fair market value, you can expect to owe taxes. The amount of the bargain element (or the discount you received on the stock by exercising it, calculated as the fair market value minus the price you paid) has a required withholding tax of 22%, similar to RSUs. If you are in a higher tax bracket, your taxes owed will be a similar calculation to RSU vesting, or you’ll owe the difference between your current marginal tax bracket and 22%. Incentive stock options are much more complex, and beyond the scope of this blog, but if you’re considering or have already exercised incentive stock options at a discount, you’ll want to work with a CPA to ensure you cover any alternative minimum tax requirements. For more information, check out our blog: How Are My Employee Stock Options Taxed?
Additional income, such as self employment, dividends, interest, capital gains, or real estate income
Similar to stock compensation, any income on top of your cash compensation should be evaluated using your marginal tax bracket. If you know you’re paying enough in tax on your cash and stock compensation, and the combination of all other income represents 10% or more of your taxable income, it’s worth considering if you should make estimated tax payments.
Unlike W2 income, taxes are not automatically withheld from these income sources. For self-employment and real estate income, we recommend keeping records of all income and expenses. You’ll be responsible for paying taxes on the net profit of the business or real estate properties, calculated as income minus expenses. For investment income, all information can be found on your brokerage account statement. Even if you don’t withdraw the funds, if you earn dividends, interest, or sell investments and generate capital gains, you’ll owe tax on that income for the year. Estimated taxes should be paid based on your marginal tax rate.
When it gets complicated, hire a professional!
If the math in this blog has your head spinning, you do not have to worry…there are qualified CPAs and financial planners out there to help you figure this stuff out! We absolutely recommend consulting with a professional tax expert to determine your tax obligations, but you can also use this blog to arm yourself with information and gain some foundational knowledge, so you can ask the right questions in discussions with tax and finance professionals.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.