Dear Liz: I live totally on my investment income. I receive the majority of my income at the end of the year, mostly dividends from my brokerage account.
A couple of years ago, when talking to an IRS agent about another matter, I asked when I should make my estimated tax payment. I was told that I had to make the payments quarterly. This year, when I was talking to my accountant, she told me that I could make a lump-sum payment at the end of the year without incurring a penalty. Who is correct, the IRS agent or my accountant?
Answer: Ours is a pay-as-you-go system, and the IRS assumes that your income is received evenly throughout the year, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Therefore, the agency typically expects four estimated tax payments of roughly equal size, with the payments due April 15, June 15, Sept. 15 and Jan. 15. If the payments aren’t made as expected, you can get hit with an underpayment penalty.
However, the IRS allows a taxpayer to show that their income is not earned equally throughout the year by filing a Form 2210 with a related Schedule AI (Annualized Income Installment Method), Luscombe says. Schedule AI allows you to show when income was earned during the year so you can match your estimated payment dates to when you actually received the money.
Schedule AI is more work, since it requires you to report adjusted gross income for each of the four quarters, as well as your itemized deductions and other tax details items, Luscombe notes. But if your income comes at the end of the year and the corresponding estimated tax payment was made on Jan. 15 of the following year, filing this paperwork may be sufficient to avoid a penalty for underpaying estimated taxes, he says.
Dear Readers: The following comment was prompted by my response to the letter from a couple in their 70s asking if they had made a mistake moving their $2-million portfolio, including $340,000 in a taxable account, to a new advisor. The advisor recommended investment sales that resulted in a $50,000 capital gain tax bill, and their accountant disapproved. I wrote that the tax pro might not be in the best position to judge whether the sales were necessary, since accountants are typically focused on reducing tax bills but sometimes diversification is necessary to avoid even bigger financial consequences down the road. Here’s another perspective.
Dear Liz: The comment that the accountant is not in the best position to evaluate is correct, as the accountant is only looking at the taxes. However, as a retired portfolio manager and chartered financial analyst, I really doubt that it was appropriate for the investment manager to take this large of an amount of capital gains. It would only make sense if this taxable portfolio had nothing but speculative issues in it, which I would find doubtful for a couple in their late 70s. If the taxable account was too high in equities or poorly diversified by industry weightings, adjustments can be made in the larger retirement account to bring the combined account into better balance. It may have been appropriate to take some gains, but they can certainly be spread out over several years, as taking them all at once likely puts the couple in a higher tax bracket.
Answer: You’re making a good point that the couple had other options besides “ripping off the Band-Aid” and incurring one big tax bill rather than taking the gains more gradually. Their new advisor, as a fiduciary, should have discussed the options with them and helped them understand the impacts, including the expected tax bills and potential impact on Medicare premiums. If those discussions didn’t happen, that’s all the more reason to seek out a second opinion from another fee-only financial planner.
Liz Weston, Certified Financial Planner, is a personal finance columnist. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.
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