The IRS Monitors Divorced Individuals’ Payments of Estimated Taxes.
The IRS rules are straightforward for divorced individuals who receive child support or alimony payments. Most recipients (women, predominantly) understand how these rules work. When Form 1040 time rolls around, they aren’t taxed on child support payments, provided their divorce decree specifically distinguishes these payments from alimony. But they do have to list alimony payments on their returns.
Unfortunately, year after year, many recipients belatedly learn the expensive way about another long-standing requirement. The IRS insists that they comply with strict regulations for making payments of their estimated income taxes. These constraints kick in when estimated taxes for the year in question exceed $1,000.
Alimony recipients usually must pay estimated taxes in four installments for each year. Here’s how the rules apply to hypothetical recipient we’ll call Charmaine. Her due dates are April 15, June 15 and Sept. 15 of the current year and Jan. 15 of the following year. However, the IRS allows Charmaine to skip January’s payment, provided she submits her return and pays her tax in full by Feb. 1 of the following year.
What Charmaine should do to avoid unnecessary payments. She needs to keep track of withholding for taxes on payments received by her as salaries, wages, bonuses and other types of compensation during the current year. Her tally is incomplete if she forgets to include an overpayment of taxes for the previous year that she elected to apply to her bill for the current year.
Penalties for underpayments. The law authorizes the IRS to assess stiff, nondeductible penalties should Charmaine fail to pay sufficient tax during the year through withholding or estimated payments or fail to pay required installments on time as they become due. Suppose she submits a final estimated payment that’s sufficient to wipe out any balance due when she submits her 1040 form. That cuts no ice with the IRS.
The agency allows atonement for shortfalls in payments by increasing withholding from paychecks. Assume the IRS could penalize Charmaine for insufficient estimated payments throughout the year. Will it refrain from assessing penalties for underpayments in the three previous quarters if Charmaine pays the shortfall through an increase in her last quarterly estimated payment? That won’t work. What works is when she makes up the shortfall by boosting withholding from wages (or from sources such as Social Security benefits, pensions, and money removed from IRAs and other kinds of tax-deferred retirement plans) towards the end of the year. Why? Because the IRS allocates Charmaine’s withholding equally over each of the four payment periods. Therefore, her increased withholding can retroactively lessen or eliminate penalties when a similar increase in an estimated payment mightn’t.
“Safe harbor” rules for sidestepping penalties. Another escape hatch for Charmaine is to qualify under one of the IRS-authorized “safe harbors” or exceptions. They excuse her from any penalties for underpayments of more than $1,000 for estimated or withheld taxes. (No penalties when her underpayments stay below $1,000.) To qualify, Charmaine has to satisfy a two-step requirement:
Step one: She makes payments by the due dates.
Step two: Her combined payments of estimated and withheld taxes equal at least 90 percent of the actual taxes she owes for the current year or 100 percent of the previous year’s total tax liability—whichever is the lesser figure.
The exception based on her prior year’s tax is available even if the amount due was zero, provided she filed a return that covered 12 months, as she ordinarily would.
As the prior-year exception uses a fixed number, it’s the easiest way for Charmaine and most other recipients to figure their payments and dodge underpayment penalties. To illustrate, her payments total $13,000 for the previous year and $13,000 for the current year. With those kinds of numbers, Charmaine’s home free, no matter how much she owes when she files for the current year.
The agency applies stricter rules when her adjusted gross income (the amount on the last line of page one of Form 1040) exceeds $150,000 ($75,000 for married persons who file separate returns). It permits Charmaine to use the 100-percent escape hatch only if her payments equal 90 percent of the current year’s tax liability or 110 percent of the previous year’s total tax—again, whichever is less.
Exception for “annualized” payments. The IRS authorizes another exception when Charmaine pays ninety percent of the current year’s total tax, figured by “annualizing” income actually received by the end of the quarter in question.
The annualizing exception helps Charmaine when her income from alimony and other sources unexpectedly increases or fluctuates throughout the year. But the calculation is complicated.
Free help from the IRS. More detailed information is in Publication 505, Tax Withholding and Estimated Tax, available at irs.gov or call 800-TAX-FORM.
Julian Block writes and practices law in Larchmont, N.Y. and was formerly with the IRS as a special agent (criminal investigator) and an attorney. He is frequently quoted in the New York Times, the Wall Street Journal, and the Washington Post, and has been cited as: “a leading tax professional” (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). This article is excerpted from “Julian Block’s Tax Tips for Marriage and Divorce,” available as a Kindle at Amazon.com and as a print copy at julianblocktaxexpert.com. Law professor James E. Maule, a professor at Villanova University School of Law and Graduate Tax Program, praised the book as “An easy-to-read and well-organized explanation of the tax rules.” The National Association of Personal Financial Advisers says it is “A terrific reference.”