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Don't Fall Into This Painful Tax Trap

Tax trapEvery year, millions of people look forward to getting their tax refunds. But if you're one of those unfortunate folks who has to write the IRS a check every year, you might get even worse news: an extra bill for interest and penalties.

Most workers have their employers withhold taxes from their paychecks. If you correctly fill out the W-4 Form that your employer gives you, then the amount taken out of your paycheck should be enough to avoid any interest and penalties.

Typically, as long as you owe less than $1,000 in tax after you account for withholding and tax credits, you're in the clear. Also, if you paid at least 90% of the tax you owed in the current year, you usually won't get hit with a penalty.

But if you owe more -- especially if you earn income as an independent contractor or own a business -- then you'll need to make quarterly estimated tax payments to avoid getting hit with penalties.

How Much Do You Have to Pay?

Calculating estimated taxes is nerve-wracking even for tax-savvy people. Figuring out how much you owe this year is hard enough. Trying to guess how much you'll owe on your return for next year seems close to impossible.

That's why the IRS has a simple rule to make it as easy as possible to avoid penalties. For most taxpayers, if you take your total tax from your last year's return and divide it by four, making four equal quarterly payments of that amount this year is guaranteed to keep you from owing penalties. For those who earn $150,000 or more in adjusted gross income, you'll have to pay slightly more -- a total of 110% of your last year's tax.

That rule works even if you have nothing withheld from any paycheck. Those who do have tax withheld can reduce their payments accordingly.

Keep Your Money

Even if you slip up, penalties aren't the end of the world. Because interest rates are so low right now, the penalty amount for your 2011 taxes is only about 3% to 4% annually.

But since it's easy to avoid penalties, there's no reason to pay even that much. So don't give the IRS more than it deserves -- keep your hard-earned money for yourself!

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You don't pay interest nitwits. Interest does not enter into the equation until the due dat of the returns (April 17th this year). It is a statutory penalty that doesn't change with the interest rate charged or paid by the Treasury. More journalists writing about stuff of which they know nothing. It is a stated 10% Penalty but since your underpayment starts at zero and ends at 100% it is effectively a 5% penalty. Usually even less as you pay based on the lower of the exception amounts. Not worth incurring in todays environment, but when times were better and you could get better low risk retuns lots of people paid the penalty and made more with their money elsewhere.

March 06 2012 at 3:18 PM Report abuse rate up rate down Reply

Since retirement, we make quarterly payments and the 10% penalty is a concern since our income is highly variable. We keep a monthly spread sheet - and it seems to be working so far. Thank God I learned Excel!

As an aside - writing a check to the US Treasury 4 times a year make you question even more where all the money is going and how well it is being spent. You can bet that compliance would be low if there was no payroll withholding.

March 05 2012 at 7:46 AM Report abuse rate up rate down Reply

It's "nerve-racking," not "nerve-wracking." A good piece nonetheless.

March 02 2012 at 4:41 PM Report abuse rate up rate down Reply