estimated tax and federal underpayment penalty

[Dan08558]

Hello Expert, I am retired and I paid total federal income tax about $2000 in 2022. I was not expecting any tax liability in 2023 so I did not make any estimated tax payments. However, I had a large investment income in the last few days of December 2023 because one of my stock holdings was bought out by another company resulting in capital gain (I did not plan to sell my stocks in 2023 originally). Now my tax liability for 2023 is about $10,000. I understand that normally if I paid estimated tax more than my total tax due in the prior year ($2000 in 2022), I will not be subject to penalty for the 2023 tax year. Because I did not pay any estimated tax for the first 3 quarters of 2023, my question is if I pay $3000 estimated tax for the 4th quarter prior to the Jan 16th 2024 deadline, would I avoid the penalty since I paid more than the $2000 total due of 2022? Or do I have to pay $9000 (90% of the estimated 2023 total due) by the Jan 16th deadline in order to avoid the federal underpayment tax penalty? Is there any IRS publication / guideline specific about this situation? Thank you!

[Mike9241 · Accepted solution]

The default for avoiding penalties is 25% of your tax liability, the smaller of 2022 or 2023, is due each period. Assuming that for 2022 your adjusted gross income was less than $150,000, and $2000 was your tax liability then the required minimum estimated payment together with any withholding for each period in 2023/2024 was  $500 (25% of your 2022 tax liability). The due dates were on or about 4/15/2023, 6/15/203, 9/15/2023 1/15/2024. Since you did not pay taxes based on either the above or 90% of your actual 2023 for the first 3 quarters you will be subject to penalties for the first 3 quarters despite what you do for the fourth quarter. The sooner you pay that $2000, the lower the penalties will be because they are figured from the installment due date to the date actually paid.

you have the option of using the annualized income method on page 3 of the 2210 to see if that will lower your penalties. This method is based on your 2023 liability and 90% of the taxes for each period must be paid in on a timely basis.

If this is your first time incurring estimated tax penalties you could request a waiver, but it would seem the penalty will be small  so if may not be wise to use this one-time exception. 

[Dan08558]

Mike9241, thank you so much for your prompt reply. Your explanation is clear and easy to follow. I just submitted $3000 estimated tax payment today on the IRS Direct Pay website. If I understood correctly, I will be responsible for tax penalty for the first 3 quarterly payment of $500, which I assume is roughly the interest of $500 from 4/15/2023 to today + interest of $500 from 6/15/2023 to today + interest of $500 from 9/15/2023 to today. My extra $1000 payment today should cover more than these interests so I will not incur further penalty even though I don't know what interest rate IRS uses. I just want to make sure the penalty will not be calculated based on my 2023 tax liability, which will be significantly higher than 2022. I will not use the annualized income method since I will have to pay 90% of 2023 liability by 1/16/2024. I would rather pay the small penalty and allow the 90% of 2023 liability to earn interest from 1/16 to 4/15/2024, which will be more than the penalty. Please let me know if my understanding is correct. Thanks again and happy new year!

[dmertz]

You'll still want to annualize income to minimize underpayment penalties for Q1 through Q3 no matter when you pay the balance due.