How to Pay Estimated Taxes When Income Is Erratic

It’s the season to settle estimated taxes for the year, which is particularly difficult for high earners. They often have a grab bag of inherently unpredictable income sources, from bonuses to stakes in private equity and hedge funds; accurately estimating the tax tab can be a hair-pulling exercise. “I don’t think anybody gets it just right,” says Mitch Drossman, national director of the wealth-planning strategies group at U.S. Trust.

On the surface, the rules are simple. If you draw at least $1,000 a year in self-employment or investment income, rent, gambling winnings, or any income from which taxes aren’t withheld, you have to pay estimated taxes every quarter for what you think you will owe for the year. The IRS runs a pay-as-you-go system, of course, which means that if you don’t pay by a quarterly deadline, you will be charged 3% on the amount due, plus a surcharge that was recently 0.81%. That’s even if you overpay your taxes for the year and qualify for a refund at the end.

It’s irritating. Overpay your estimated taxes and you’ve given the IRS an interest-free loan; underpay and you’re paying extra interest charges. Hedge fund investments can, for example, make the task devilishly complicated. Managers of hedge funds will send you their investment-income estimate for the year, but they’re often inaccurate. “I’ve had cases where clients were relying on estimates from funds, but the estimates turned out to be off by almost half-a-million dollars,” says Michael Malakoff, managing director of Ascent Private Capital Management’s Center for Wealth Impact.

It’s a complex process with lots of moving parts. Take state taxes. While most states follow the IRS payment system, California, for example, requires taxpayers to pay 30% of their estimated taxes in the first quarter, 40% in the second quarter, none in the third quarter, and 30% in the final quarter. That’s just one more sneaky detail to trip up the unwary taxpayer.

Don’t stress. There is some breathing room. As long as you pay taxes on at least 90% of the year’s income through estimated tax payments and withholdings, the IRS won’t get punitive. (Conversely, prepay taxes on less than 90% of your income and you’ll pay the interest charges.)

There’s potentially more relief available in the so-called safe-harbor IRS rule. Earn more than $150,000 and you can pay 110% of the prior year’s tax bill over four quarters and—no matter what your tax bill turns out to be for that year—the IRS will accept those estimated tax payments as sound. Folks earning $150,000 or less must pay 100% of the prior year’s tax bill. This works well if you believe that your tax bill will be at least the same as the prior year, or higher.

Trouble arrives when income declines, as happened to a Malakoff client primarily investing in private equity, real estate, and hedge funds. “My client doesn’t control what happens in the funds,” he says. “In some years, they pay dividends and interest; in some years, big gains.” Last year, a property sale in the real estate fund meant a big payday that was unlikely to be matched this year. You could still pay 110% of last year’s tax bill in that situation and get a refund, but then, he says, “you’re earning 0% on that money you overpaid, and could have gotten a much better return on that liquidity in the markets.”

So you’re stuck with predicting your income so you can come close enough to paying taxes on 90% of your quarterly earnings streams. The challenge to estimating taxes accurately, besides all of the erratic income sources, is that “you are dealing with three different tax systems—the 3.8% Medicare tax, the alternative minimum tax, and the regular income tax. You need to look at everything—itemized deductions, phaseouts, credits, everything—to come up with a good estimated tax payment,” says Scott Berger, a principal at tax firm Kaufman Rossin in Boca Raton, Fla. “You almost have to run a complete return quarterly.”

Which is ludicrous and expensive. So, if you also have salaried income and realize a couple of quarters in that you’ve been underpaying your estimated taxes, ask your employer to increase your withholding from your salary for the rest of the year, which is acceptable to the IRS, says Garrett Gregory, an attorney at Gregory Law Group in Dallas.

Your last get-out-of-jail-free card is to make a massive withholding in a later quarter, to back-pay the underpaid taxes in previous quarters, but it’s dangerous to overuse this option. Chronic underpayment is a red flag, and could trigger further IRS scrutiny.

And that’s the last thing you need.