Filing an “Application for Automatic Extension of Time To File U.S. Individual Income Tax Return” is not bad, does not increase your taxes and allows you an additional six months to accurately prepare and file your tax returns. The key word in this is “File”. The form and related extension process allows an extension of time to FILE your returns, not an extension of time to pay your tax bill.

There is no extension of time to pay income taxes. If you utilize the practice of extending your return in order to “buy time”, you will experience an unpleasant surprise. You might say that you really are buying the time. This is because after you do file your returns and pay your taxes due, you will receive a balance due notice within a couple months. This notice will acknowledge that you have paid your taxes but will assess you for interest and penalties from April 15th until the date that you finally paid your tax bill.

If you are not going to pay your taxes until later than April 15th, it is still of value to file for an extension if you are also not going to file your returns by April 15th. This will keep the balance due notice from including a late filing penalty. This is not to be confused with the late payment penalty. They are two different penalties.

Proceed with eyes open and fully informed.

File an extension if you need it, but be sure to pay the amount you estimate owing with that extension. Failure to pay your taxes, in full, even with a properly filed extension, leads to underpayment penalties, late payment penalties and interest on the outstanding balance from April 15th until the date you make your payment.

Personal Extension: Form 4868
Business Extension: Form 7004

Unfortunately for anyone in this situation, the first of the four quarterly tax deposits for this year are due on April 15th, the same day that you must settle up with any amount due for last year. It is not unusual to find that it is all you can do to scrape together the taxes due with your returns. This can understandably leave you unable to afford to pay your 1st quarter estimate.

Does this mean you will owe big penalties for this year?

It can, but it does not have to. First of all, you will not be able to determine your actual amount of 1st quarter underpayment until the end of the year. This is because if your current year income is lower than last year, the amount of your underpayment may also be lower than you may think.

The Key.

By missing the 1st estimate, if you make each successive estimate on time, you will leave yourself with the possibility of being underpaid each of the four quarters (all year). This can definitely lead to unpleasant penalties by the time you get to April 15th of next year. The key is to catch up as soon as financially possible. For example if you double up in your second quarterly estimate, you will mitigate the penalties by only being underpaid the first quarter. This theory applies to any estimate that you may find yourself unable to satisfy throughout the year.

By striving to catch up, you minimize the occurrences of underpayment. By minimizing the occurrences of underpayment, you minimize the resulting underpayment penalties.

Golden Nugget.

By increasing your payroll withholdings, you may totally eliminate the occurrence of being underpaid. W-2 reported withholdings are considered to be equally withheld throughout the year. Consequently, if you miss a first quarter estimate, but are able to increase your withholdings by an amount that eliminates the need to pay any estimates this year, you may effectively eliminate any potential underpayment penalty for late or underpayment of this year’s income taxes.

What are Income Tax Estimates?

Quarterly income tax estimates are payments designed to fulfill the “Pay as you go” concept of the US tax system. They are similar to withholdings that employees pay from each payroll. Who pays these estimates? Generally, estimates are paid by taxpayers that have sources of income that are either unearned (interest and dividends) or are earned in a manner other than as an employee (self-employment income). It is their primary means to be sure that certain minimum tax deposit requirements are satisfied throughout each year.

How do I know if I should pay estimates?

Hopefully, your CPA will advise you of this need by performing the calculations and preparing the estimate coupons and instructions in connection with your annual income tax preparation process. If not, you can have some indication that you should pay estimates if you owe more than $1,000 with your tax return (State number vary by State).

Now for the meat of the topic.

The answer you really want to know, Do I really have to pay these? Well, you will love this… No you do not have to pay Income Tax Estimates. You can continue to pay all of your tax balances with your tax return each year. That is still your choice. But please beware. There are consequences to that decision. If you do not reach certain minimum tax deposit levels, either through equal quarterly income tax deposits, or through payroll withholdings, you will likely suffer penalties and interest on the amounts that you owe. One key alternative to the quarterly payment is to increase the level of payroll withholdings such that they cover not only the withholding level previously set, but also the additional amount needed to satisfy the calculated Income Tax Estimates. This is another example where a well planned and prepared W-4 (and/or state equivalent) can improve your finances throughout the year as well as at year end. For mor information on W-4s see“Updating W-4 Forms – Avoid an Unpleasant Surprise”

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Estimated-Taxes
http://www.irs.gov/pub/irs-pdf/f1040es.pdf

The W-4 form determines how much is withheld from your paycheck. There is no requirement that you update this form after you initially file it with your Employer, but based on life changes and undesirable annual income tax return results, you may want to update your form a couple times a year.

When?At the beginning of each year you should adjust for life changes. Married or Divorced, increase or decrease in dependents, or a move to a different State, city or town, or county/local taxing jurisdiction? These can all cause you to need to make potentially substantial changes to your W-4 for a new year.

Maybe more important than the previous example, you may consider having your CPA or tax professional provide you with an analysis of your current withholdings as a planning point for your next income tax filing. This can be done sometime after you have prepared last year’s returns (approx. April 30th) and in some cases again later in the year (approx. September 30th). Having this analysis performed at either one or both of these post filing times of the year can help you to maximize your monthly take home pay while providing some level of assurance that you will not be adversely affected (Surprised) at year end.

If you ask your CPA or tax professional for this analysis, it may cost anywhere from $25 to $40. The peace of mind may be well worth the investment. Alternatively, you can complete the worksheets on page 2 of the W-4 form yourself. This should walk you through the process and provide a reasonable answer. Be sure you adjust for any withholdings already processed during 2013.

You can submit a new W-4 form to your employer at any time during the year and as often as you feel it is necessary. With a little bit of an investment of time and money, you should be able to minimize the stress of the unknown related to your annual tax returns.

The form is available at http://www.irs.gov/pub/irs-pdf/fw4.pdf

Although this year’s withholding tables do not currently represent any sort of consumer spending games, and there is no requirement that you submit a new W-4 form each year, reviewing and updating your Employee’s Withholding Allowance Certificate (Form W-4) once or twice a year can help prevent a year end surprise while keeping the optimum amount in your net paycheck throughout the year.

Why update?

Life changes and undesired tax return results. Did you get married or divorced?  Do you have another dependent or two?  Did a dependent get married?  Did you move to a different State, city or town, or do you live in a different county or local taxing jurisdiction?  These life changes can greatly affect your needed withholding level.

Did your last tax return present you with an unbearably large amount due, or equally disturbing, a huge refund that could have made life easier throughout the year?

How do you make the right change to your W-4 form?  We will address that question next week.