For those in the working world whose total income comes through salary and, perhaps bonus, withholding taxes is relatively simple. While you may receive a refund or owe some money at tax time, adjustments can be made through the payroll department during the year.
But for those who have investment income, or experience a windfall income year, tax withholding can be tricky, and payment timing strategies can potentially yield some significant tax savings.
While we at Glassman Wealth manage $800 million for families, we owe it to our clients to point out opportunities to potentially lower their tax bill. In this article, I’d like to point out what happens when there’s a windfall year, and how the timing of state tax payments could add up to tens of thousands of dollars in savings.
For the most part, the IRS and states want their tax money during the quarter in which the income is received. But there are certain safe harbor provisions that allow you to delay these payments until tax time the following year. However, many mistakenly believe that holding on to the tax money until tax time is the best strategy. After all, why give money to the IRS or state until you absolutely must?
There’s a significant reason to pay your state income tax bill earlier than required, especially in a year where your income increased substantially.
First off, this strategy only applies to a rare income event – not something that would be part of your normal paycheck. Let’s say for 2013, you earned $200,000. You also expect to earn $200,000 again in 2015. But in 2014, you experience your big one-time event and your income zooms up to $2 million. Well, as exciting as all that income is, it also means you’re going to pay some serious tax on it.
Fortunately, that’s when this simple, but effective strategy may have a huge impact on the amount of state tax you will ultimately pay.
Why not pay state taxes immediately?
When given the option, most people wouldn’t pay state taxes until they HAD to. Most states, including Virginia, require 100% of what you paid the prior year withheld, or paid in quarterly estimates during the current year. The rest is due the following April.
If you live in a state that doesn’t have an income tax, you can move on. In Virginia, we pay a state tax rate of 5.75%. Going back to our example, you would normally pay $11,500 to Virginia on your income of $200,000 (short of any deductions you might have.) But the year you earn $2 million, you’ll owe $115,000 in state taxes. Ouch!
So if you paid $11,500 in state taxes for 2013, your state wants at least this figure in 2014 (through withholding or quarterly payments) to avoid penalty and interest next April. In this example, the remainder will be paid with the state tax filing in April.
Note: Holding on to this money until April was often valuable. In years past, people could earn a decent rate of interest in a CD or money market fund while hanging on to the tax funds until due. In today’s low-interest rate environment, there’s just not a significant amount of safe yield in these types of investments to make this worthwhile.
So, if I don’t have to pay the balance until next April, why do it?
The question is: “When is the most value achieved from the state tax deduction?” Even though the state may not require the funds until next April, they are deducted from income in the year in which they are paid. So, if the check is written in December 2014, the deduction will be applied to the 2014 return. A check written in April 2015 will be applied to 2015.
Let’s look at an example of the two options – paying state tax in the year after it’s earned and paying it in the year it’s earned.
If you have a windfall year, you may want to be sure to use the deduction in the year in which it is most valuable. In our case above, the deduction will likely be more valuable in the windfall year for two reasons. First, you may find yourself in a higher tax bracket. It’s better to use the deduction while paying at the highest (39.6%) tax bracket.
Next, comes AMT, the Alternative Minimum Tax. In the spirit of simplification, the tax code just does not allow someone to deduct most of their income with things like taxes and mortgage interest. So, when filling out the IRS forms, they make tax payers calculate their taxes two different ways. First the traditional way, which in the first example of paying taxes the year after income is earned, produces a Federal tax bill of $7,385. However, the IRS says, ‘nice try’ but we did your math our own way, and you owe another $30,120 for AMT.
In our example, the state tax deduction is more valuable, to the tune of over $32,000, in the year of the windfall.
Do Your State Tax Homework
To find out if it might make sense for you to prepay your state taxes, talk to a CPA or tax professional who can walk you through the different scenarios (also ask them about reducing your withholding for the following year when your income returns to normal). You may also want to talk to them about how you can bump up your charitable donations for the year – even giving next year’s amount this year – since those deductions are not part of the AMT.
Again, it’s a good idea to think and plan ahead, especially in high-income years, to potentially lower your tax bill and eliminate any disappointing tax surprises.