Tax Underpayment Penalties: Podcast #480

by | Jun 27, 2024 | Podcasts

Tax Underpayment Penalties: Podcast #480

Key Take-aways:

  • The podcast discusses the rise in tax underpayment penalties, with the number of filers impacted increasing from twelve million to fourteen million and the amount owed rising from $1.8 billion to $7 billion.
  • The underpayment penalty formula is the rate on short-term treasuries plus three points, which is currently around eight percent.
  • Retirement planning must account for taxes on various income sources, including social security, pension income, and capital gains, which are taxed differently.
  • Many people overlook the need to withhold taxes on interest and dividend income, which can lead to unexpected tax underpayment penalties.
  • Proper withholding and estimated payments are crucial to avoid underpayment penalties, especially for those with diverse income sources like self-employment, investments, and retirement accounts.


Tax Underpayment Penalties: Podcast #480 – Links

Catch All the Mullooly Asset Podcasts Right Here
Or, on Apple Podcasts
Or, on Spotify Podcasts
Wall Street Journal article


Tax Underpayment Penalties: Podcast #480 – Transcript

Welcome back to the Mullooly Asset Management podcast. This is Brendan Mullooly joined by Tom and Tim today and this is episode 480. Right? Yes, it is. Correct.

“Host!” Brendan Mullooly. Yeah!

He’s going to try to bring us through a pleasant topic today, of course, with taxes. Always pleasant. Ben Franklin said that the only constants in life are death and taxes or something along those lines. Right. Yeah. Death, taxes, and the Mets winning on opening day. I’m just kidding.

Well, I think when he said that about taxes, he forgot about the underpayment penalties that you can also owe on taxes. It’s interesting that Ben Franklin talked about death and taxes, and the IRS hadn’t even been established yet. He was referring to, I guess, the Constitution had just been ratified. I think that was what that was in regard to. Taxes have been the bane of our existence since the beginning of this country.

I mean, that’s kind of part of the reason why it was founded to begin with. Taxation without representation. But no need for a history lesson. The point is, we wanted to get to tax underpayment penalties because I think everybody understands that we owe tax when we have income, but not everybody understands that we can also owe a penalty on that tax if we don’t withhold it and pay it at the appropriate time.

There was a Wall Street Journal article that reported that both the number of filers and the amount of those filers paying tax underpayment penalties have risen over the last few years. The estimates were year over year up from twelve million filers impacted to fourteen million, as well as an estimated seven billion dollars in tax underpayment penalties owed, up from one point eight billion.

That is an astonishing number, seven billion in underpayment penalties, and that it’s gone from a number under two billion to now over seven in just a couple of years. That’s a quick escalation. Clearly, people are not doing things properly in terms of being properly withheld on their taxes or paying things like quarterly estimates at the right time or underpaying.

It’s interesting to see or to think about why it might be happening now, but I think it’s important to understand how all of that works in general. I have to admit I did not know. I said this before the mic was turned on. I did not know that there was a formula for calculating what the penalty for the underpayment penalty would be.

But it turns out that it’s the rate on short-term treasuries plus three points. So those rates are around eight percent now, which is a large factor in at least the amount being higher but also the number impacted by it suggests that there’s more to it. And that’s probably more than what Tim had mentioned in terms of people either not keeping track of these income sources well or not adjusting withholdings to account for different factors that can make your taxable income higher in any given year.

I think that’s a good segue to what is an underappreciated aspect of the retirement transition that we help folks with, which is not just replacing their income, but also replacing their tax mechanism. Most people earn an income from employment and have their taxes withheld as a part of that. So it’s not only the income we’re replacing when we’re making retirement plans but also considering how to get the taxes withheld too.

I think a big part of that and the exercise that we go through for people, one of the more valuable points is getting, you know, we’re trying to figure out how much money they need per year in retirement and we get to a gross number. But then we have to whittle that down to a net number and it’s sometimes eye-opening to explain to people that you need to account for taxes even in retirement.

Because whether it’s something like social security or pension income or even just selling investments in a brokerage account, there are capital gains taxes, not just regular income taxes, and then money coming from retirement plans that’s being taxed on the way out unless it was Roth dollars.

All of that put together, you need to still be really withheld through retirement. That part doesn’t just end when you stop earning your normal salary. Would you say that not factoring in taxes is one of the larger oversights that people, one of the missteps that people make when they’re trying to plan out their retirement? That and healthcare. And interestingly enough, healthcare is another thing that is often attached to employment and therefore income. So that trio of, hey, we have to replace the income but also, like, what things have been attached to the income that you’re forgetting about here and that’s attached and then insurance beyond it.

So yeah, it is one of the biggest things that is overlooked, I would say. People see their net pay in their paycheck. They’re not even considering, hey, I had money taken out for Social Security, for disability, for Medicare, but also your federal and your state income taxes. You’re just not even thinking about it because this happens with their payroll. And you can recreate that system, but I think as Tim alluded to, depending on the source of the income, you have some choices to make in terms of how you arrive at not only what your taxable income will be but I guess how you withhold and then get that money to the IRS altogether.

I guess a good problem to have because if you’re diversified enough to have these choices to make, that’s a good thing. You want to have different options at your disposal in terms of the tax status of your assets and being diverse there, whether it be banks versus brokerage accounts versus retirement accounts versus social security, like all of those things are taxed differently.

So maybe thinking through what some of these common sources are, talking it through, would be helpful for listeners in terms of common sources of income we see, their taxability, and their withhold because you can’t withhold on all of these different types of income which is what makes it so complicated, I think.

Alright, let’s dig into the list. I have a list here. Maybe we can just touch briefly on some of these, but for starters, interest and dividend income. I mean, that’s not really something that you can withhold on ahead of time. A lot of times, you know, you could see what a company has paid out in dividends or, you know, historically, but that can change at any given time and you can’t really withhold that ahead of time.

You have time to talk to us. And you can’t just bypass it and you know, like that it needs to be considered. So, can’t withhold for it but definitely needs to be accounted for. I also think that a lot of folks are getting caught flat-footed because for about fifteen years from two thousand and eight through a year or two ago, they earned nothing at the bank. And so they didn’t have any interest. They may not even have had a ten ninety-nine issued if it was below the de minimis threshold.

Now they’re getting a ten ninety-nine, you know, even for just a healthy emergency fund that might be a couple thousand dollars a year of interest. That’s taxable as ordinary income before talking to the bank out. And I actually thought when I was reading about the increase in tax underpayment penalties that that might be one of the biggest sources of it, people not reporting the interest on just their savings accounts. We’re people that have been gung-ho about things like CDs over the last twelve to eighteen months now with where they are, not remembering that that is taxable income.

And so that, you know, it’s not just free money. You know, like the feel like people have gotten very, like you said, gung-ho about wanting to, you know, I can get four or five percent at the bank now or in a CD. It’s like, that’s true. But like, you have to what’s the after-tax? What’s the after-tax? Exactly. So it’s not just, you know, you get that money and you get to keep all of it. You know, the government wouldn’t do that.

If it’s significant enough, it can throw off, like you could nail the rest of your withholdings. And if you don’t account for that and you’re in your withholding estimates, you could be off by enough that you’re in a position where then the IRS is recommending estimated payments for the year ahead. And then if you don’t make those, you could end up with tax underpayment penalties like we began talking about.

So it’s like a big puzzle piece and they’re all different sized pieces, but they all fit together and it’s your job to kind of assemble it. They don’t really give you the instructions necessarily, or they give you the instructions but they’re in a different language. You know what I mean? Like, it’s not as straightforward as some people would like. A lot of people, I would say probably most people, don’t make the accounting entry to say I have to slice some of the interest off of my CD to send it in for quarterly withholding.

They pay it out of some other source. Likewise, if you’re reinvesting dividends, you don’t have that dividend yet. It’s going to be taxable to you in a taxable brokerage account but still have to account for it. The term is phantom income. You recognize that income on your tax but it doesn’t actually hit your bank account in cash form. It goes back into your investments.

I feel like a lot of people may not account for that. So dividends and interest, taxable, yes. And that’s even a complicated answer when it comes to qualified dividends or not. Maybe we’ll save that for another podcast entirely. So taxable, yes, as most income sources are, but then also “withhold-able,” no. So you have to incorporate that into your plan and see where you can possibly get the money that you owe to the IRS in a timely fashion so you don’t end up owing a tax penalty on it.

The next one that comes to mind is capital gains. And, I mean, capital gains, whether they’re short-term or long-term, they’re taxed differently. But even long-term capital gains, which tend to be lower than short-term capital gains, you know, they’re still definitely taxable. So it’s, I don’t know if you could say that you can really withhold for them ahead of time. But you know, like you can kind of again, like mentally factor it in when you’re looking at your after-tax return, you can like kind of physically separate it if you want to or just mentally account for it off to the side. But it’s not really something that’s like built-in “withhold-able.”

So with non-automated with, I think, like easily automated done for you. So you not like a paycheck withholding. It’s like, you know, you have to make some kind of exactly book entry item for that. And to avoid a tax penalty, if you have a big capital gain that you recognize, the estimated payment should be done in the quarter that the income is recognized. Otherwise, there’s going to be a penalty owed on it. I think that’s another part that people sometimes miss is the timing of things like quarterly estimates.

So you can make up for not sending in an estimated payment on income recognized like this with other sources of automated withholding that get sent to the IRS. But that was in the article from the Wall Street Journal. They were talking about the timing of getting the income there and how there’s a tax form to file in the event that there’s a timing mismatch in terms of when the payment was made and when the gain was recognized.

But when we’re talking capital gains, we could be talking about stuff done in a brokerage account. We could be talking about selling real estate, like any variety of ways you could get to a capital gain and it isn’t something that gets withheld in the transaction. And often that is a point of confusion for folks if they’re calling up for money from an account and they’re used to withholding on the transaction like you can on a retirement account. I’d say you can’t do that from a brokerage account, but it doesn’t mean the transaction isn’t taxable.

That depends on what you’ve sold and how long you’ve held it. So a little complicated, but it’s good to have these two buckets now that we’ve talked about in terms of these would come from broker assets from a bank account. Like it’s good to have those in conjunction with these other sources where you can, where they are a little more “withhold-able.” Yeah. I think the brokerage assets, the capital gain, capital gain taxed assets versus the retirement assets is an important point for people in their retirement planning income planning because they’re taxed at different rates.

We could probably do another short podcast on that, but there are different tax brackets for long-term cap gains and ordinary income tax brackets. So trying to figure out the balance of that, whether you want to go fully retirement assets or banked and brokerage assets, the capital gains assets or a combination of the two, that can be an important exercise for some people.

So maybe onto the sources where you do have that optionality. And I would put it as optionality because you never have to withhold from any of these sources, but you have the ability to withhold as you go and have money sent directly to the IRS on your behalf. This would include stuff like your Social Security, which often comes as a surprise to people that it’s taxable to begin with. Taxable and “withhold-able” although interesting with Social Security in the sense that you can only withhold the set percentages that are offered on the withholding form, the V I think is a month for Social Security. That’s right.

Flat percentages there. And then you have pension or annuity income, and then distributions from retirement accounts. The Social Security one I think is sometimes an eye-opener for folks. So you get that number of what you can expect from Social Security and then net out taxes and if things like your Medicare premiums are being taken from that, the physical check that hits your bank account each month could end up being a lot less than what you’re expecting. And important to account for all those in their own way.

Again, you don’t have to withhold anything on it, but if you’re not withholding from there, you’re either going to have to make estimated payments or withhold from another source because you’re going to owe tax on the money whether you choose to withhold on it or not.

A lot of cases, stuff like social security or pension income or annuity income, we come across folks that already have this stuff in place being withheld at whatever rate felt appropriate when it began, and what they’re trying to do as their plan progresses into retirement is supplement from other investment sources. And so what then doing is trying to connect the dots behind the scenes in terms of, hey, maybe this social security income is being withheld.

Maybe it’s under withheld. How do you make up the difference from an estimated payment or retirement distribution to make sure that they’re tracking well? To not owe money?

Ideally, it’s like, let’s say your tax bracket is twenty percent. You could cleanly withhold twenty percent across the board from all these different sources, but it usually never works out that way. So if one of your sources of income is being withheld at ten percent, you have to make up the difference from something like a retirement account or other source of income to get up to that twenty percent number that you need to hit. So it’s an interesting calculation or something to look at that I don’t know people don’t consider sometimes.

Apparently fourteen million people didn’t consider it last year.

I think with the retirement account distributions, they end up being in a lot of cases the most flexible or easiest to alter. You can absolutely change your withholdings on stuff like pension income or annuity income. It usually involves sending in some kind of a W-4 to the provider of that, whether it be in the Social Security Administration or annuity provider, pension provider.

And in a lot of cases, different investment custodians are just easier to work with in that sense. And so we often find themselves in the role of working to determine what would be reasonable to withhold on a retirement account distribution to kind of bring all the other sources together, whether it be coordinating capital gains that were recognized in that calendar year in a brokerage account or other income sources like pension, social security, to kind of bring it withholding all and that is a pretty simple way to do it.

I think it’s a somewhat awkward conversation to have with a client when you find out that last year they had an underpayment penalty because that could be avoided if we had more information, where all the sources are, all the sources of income, what’s been withheld, what can we do about it so that this doesn’t happen again in the future. I think that’s an important part of why when we start working with people, we try and get as much info for the entire picture, all the income sources, fill out their cash flow and the balance sheet to really get an idea of all the different income sources.

Sometimes people come to us and they just want us to manage a certain account for them. And it’s like, setting aside the fact that it would be difficult for us to properly invest the money for them. Things like this, we can’t really consider any sort of tax picture for you because we don’t know what’s being withheld on other types of assets that you have as well.

So the taxes end up being a thing that people don’t understand in a lot of cases where they get them done every year and sometimes they owe and sometimes they don’t and not understanding the reasons why behind that is what seems to be a kind of a gap in the knowledge for a lot of people. And so just being able to consider all the sources, see what withholding is going on and make be, bring it all together for people is a good way to, I think, be fiduciary and be thorough and to make it doesn’t have to be a mystery.

I can appreciate the idea that the IRS doesn’t make it very easy to understand, but to the extent that we can, if we have all the info, we can kind of play interpreter to clients and solve some of those problems for them if they found themselves chronically under withheld or over withheld or owing underpayment penalties, things like that. It’s usually just not considering all the information and putting it all together.

I think also the conversation here has kind of seemed to be centered around retirement income, people in retirement, but this kind of thing applies to people at any phase of life, whether W-2 income versus 1099 income as well. Like if you’re on your own, if you don’t have the W-2 income that’s being automatically withheld and you’re self-employed or you get a 1099 from somebody, that might be that gross amount and you have to mentally set aside the money.

Or if you could have both sources of income, you have two different jobs where you’re a contractor and you get 1099 income and then you also have a salary job where you get W-2 and trying to piece those two together to come out to your proper withholding can sometimes be difficult for people.

One of the things that we can lump in with is the LLC owner who has maybe not taken a paycheck but takes a draw a lot each year and then has to calculate not only the tax on it but when did I earn it and what do I owe on it. It’s a big problem. That’s got to be a pretty big source of the underpayment penalties because especially if you have uneven income, you’re most likely when you’ve filed the prior year taxes, if you owe money or if you’re doing self-employment, you’re going to get estimate a payment vouchers that you should make, but those are guesses based on last year’s income.

And if you’re not in real time, reflecting kind of income that you Adjusting realized during the during the during the current calendar quarter that you’re paying for in the year ahead then you find yourself in a position where you may owe underpayment penalties. You could do all of the best work and even have a W2 job to Tim’s point, but if you’re trading stocks or something and you made a bunch of money that’s great.

But again you have to calculate Capital gains on that.

Because that is you only keep what you keep so I think the taxes factor into that too It’s a little bit complex in the sense that even the holdable sources of income, you have to know your numbers and do that correctly.

But these additional ones whether it be self employment or things like capital gains or interest income like these are the things that don’t get considered and you really have to have kind of a global view to take a look at all this and make sure that your square come tax time else you’re going to be one of uh one of the fourteen million now who end up owing taxes and maybe underpayment penalties too which is an unfortunate situation to find yourself in.

That’s a good place to wrap up, I think.
So, thanks again for tuning in to episode 480; and we will see you on the next one.

Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guest are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions and securities discussed in this podcast.

Join our Newsletter


Future-Proof Your Finances

Download the 25-Year Success Strategy

Enter your email & get this free PDF download to help you prepare for the next 25 years.  We will send periodic updates as well. Unsubscribe at any time.

You have Successfully Subscribed!

Share This