Why pay estimated taxes?

Question

It looks like the tax investment penalty is about 2.6%, which makes me wonder why anyone pays quarterly estimated taxes. Wouldn't you be better off putting that money into stocks and using the proceeds to pay the penalty? Obviously some people have cash flow issues and in some years stocks lose value, but assuming you're planning long term, doesn't paying all your taxes in the next year make more sense?

source: https://www.irs.gov/taxtopics/tc300/tc306

What country? In the US the penalty and interest for unpaid taxes is much higher than 2.6%. — D Stanley, Oct 25 '17 at 15:31
@DStanley He links to IRS.gov, and that link leads to a form that shows the underpayment penalty calculation using 2.6%, I thought the penalty was 4% but haven't found the documentation for that yet, maybe because it's not including interest? I got 4% from this: https://proconnect.intuit.com/proseries/articles/federal-irs-underpayment-interest-rates/ — Hart CO, Oct 25 '17 at 15:35
You can't compare to a risky rate of return - you should compare to a risk-free rate of return [ie: a money market fund which would otherwise earn you 1%]. There is 0 risk that the IRS chooses not to collect its penalty, and therefore it must be attributed a risk-free rate. [Technically there is a 'risk' that you for example lose your job in September, and therefore earn far less than you expected, and therefore you can "over-prep-pay" your taxes, but I don't think this risk is anywhere close to the risk of, for example, a mutual fund underperforming]. — Grade 'Eh' Bacon, Oct 25 '17 at 15:51
@HartCO Thanks, missed that. I was thinking of late payment, not underpayment. It may be 2.6%; I've never researched it. — D Stanley, Oct 25 '17 at 15:58
In addition to the purely financial penalties & interest, there's also the possibility that you might attract unwanted attention, increasing your risk of having your returns audited.. It;s the nail that sticks up that gets hammered down — jamesqf, Oct 25 '17 at 17:50
Would you pay for an index fund that has a 2.6 ER? Some people do. — user662852, Oct 25 '17 at 18:49
@HartCO+ yes the rate was 4% for 2016; it will change in future if short-term (<=3yr) Treasury rates return to historical norms. Your required payment (usually 90% of tax) is by default owed in four quarters as of April 15, June 15, Sep. 15, and Jan. 15, and 4% on the balances from those dates to April 15 adds up to 2.658%. If you make unequal or untimely payments, or use schedule AI to differently allocate the amount owed, you compute a 4% rate on the actual balances using the worksheet in form 2210 instructions. — dave_thompson_085, Oct 25 '17 at 20:00
Remember 'ordinary' people get most if not all of their income as pay from an employer, with mandatory withholding. Only if your income is (at least mostly) from self-employment and/or investment can you choose to omit estimated payments. — dave_thompson_085, Oct 25 '17 at 20:05
As a more fundamental question, why should the government stipulate us to pay taxes in advance at all ? What do they gain by it ? — Whirl Mind, Oct 26 '17 at 15:16
@WhirlMind: It's not payment of tax in advance, it's payment as the money is earned, at the expected effective rate. Done this way, government income is fairly steady, without a huge need for short-term borrowing to cover all expenditures between payment due dates. — Phil Miller, Oct 26 '17 at 16:22
@dave_thompson_085 if the rate is 4%, then the rate is 4%. If you're going to pro-rate the rate by the fact that it isn't for the whole year, then you also have to pro-rate the return from your investments. You might as well just use the 4% rate and skip the complicated calculations that cancel out. — Acccumulation, Oct 26 '17 at 18:40
@Acccumulation: that's true but I wasn't addressing the actual benefit or not of investing (which would be an answer) only why the figure on form 2210 differs from the actual rate. — dave_thompson_085, Oct 27 '17 at 03:24
Have you considered the happy medium? Don't pay the first three quarterly payments, but then pay the total amount you are required for the year in a single December payment. You pay no penalty and can invest the money if you want for almost the same length of time. — farnsy, Oct 28 '17 at 06:00
@farnsy it doesn't work that way. the irs actually penalizes each quarter separately. although, it is worth noting that the 2.6% rate is the average for the whole year, so the effective annual rate is closer to 5.2%, which is harder to consistently beat. i need to do some more detailed math, then i will probably add my own answer to this question. — teldon james turner, Oct 30 '17 at 16:32
@jamesturner The IRS will not penalize you at all if you have paid the smaller 90 percent of tax due for this year or 100 percent of the tax owed last year. I may be wrong in my understanding, but I think as long as you get it in by December (not april), you will have to pay no penalty. See IRS: "annualized income installment method." Is that wrong? — farnsy, Oct 30 '17 at 19:23
@farnsy yes, that's wrong. normally you must pay 25% of 90% of this year's tax due each quarter. the annualized income method only lets you pay less in a given quarter if you realized less income in that quarter. ideally, you could realize all your income in january, then only pay taxes in april of the following year, thereby paying 2.6% "interest" for a 15 month loan. — teldon james turner, Oct 30 '17 at 21:26

D Stanley · Accepted Answer · 2017-10-25T15:59:06.950

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Same argument and answer for investing instead of paying off debt, or borrowing to invest. Risk. What happens if the stocks drop by 10%? Sure, you might come out ahead on average, but a drop in the market could be catastrophic from a cash flow point of view.

In addition, federal tax debt is arguably the worst kind. The IRS has the authority to garnish wages and has virtually unlimited resources they can use to collect.

edited Oct 25 '17 at 15:59

answered Oct 25 '17 at 15:14

D Stanley

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Student loan debt is pretty obviously worse than federal tax debt. Assuming you're not actively trying to avoid paying, I would say federal tax debt is one of the best kinds of debt. It's low interest rate, and the collector is generally accommodating when it comes to making plans for payment as long as you're making an effort to pay rather than to get out of paying. – R.. GitHub STOP HELPING ICE Oct 25 '17 at 19:07
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As someone formerly in the Student Loan industry, the debt for student loans is much easier to pay off, and in fact can be written off in many cases under and income contingent payment plan. – Anoplexian Oct 25 '17 at 21:03
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Mind you that the first time you have underpayment, there is no penalty, only if you keep doing it. So you might consider that as long as historically you have been on track and penalty free, to avoid paying taxes in advance until such time that your circumstances change so much that you end up under the for the first time, and THEN you might consider paying some in advance to avoid another under year and potentially penalty. Otherwise, there is little reason to advance pay taxes, unless you have nothing better to use the funds for. Just a thought. – GµårÐïåñ Oct 25 '17 at 21:12
Given that it was the IRS that put Al Capone in jail, it is a good idea to do tax things by the book. – zeta-band Oct 25 '17 at 21:56
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The fees and penalties for not making estimated tax payments are pretty small and it's often perfectly reasonable to just not make those payments if you have something better to do with the money. Just make sure you can make the actual tax payment when it's due because the penalties and interest shoot up pretty drastically at that point. – David Schwartz Oct 25 '17 at 23:10
Having made estimated payments for several years, I prefer not having a huge tax bill plus the late fees at the end of the year. It's also good to predict your tax burden with the (possibly surprising) self-employment taxes rather than be caught off guard in March or April having to scramble or even worse use a credit card to pay your taxes. – Todd Wilcox Oct 26 '17 at 04:13
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@GµårÐïåñ: there is no exception to underpayment penalty just because it's the first time. But if your tax increases one year, perhaps unexpectedly (there are other Qs with cases), and you withhold-or-prepay the amount of the previous year's tax (or 110% if AGI over $150k), there is no penalty -- so if you owed no tax for the previous year there is no penalty even if you don't prepay. If your tax continues higher for multiple years, this doesn't help on the subsequent years. – dave_thompson_085 Oct 26 '17 at 13:16
@ToddWilcox There aren't really "late fees". You just have to pay interest, and the interest rate is around 4% now. Whether you pay estimated taxes or not, you have to predict your tax burden. Nobody, I hope, is suggesting getting caught off guard in March or April or not paying your entire tax bill when it's due in April. – David Schwartz Oct 26 '17 at 16:46
@dave_thompson_085 you just made my point for me and yet started by making a false statement. As long as you have not owed anything, the first time you do, there is no penalty, period. Then you know that you need to account for overage and make sure you avoid it, so what's your point again? – GµårÐïåñ Oct 26 '17 at 17:58
@DavidSchwartz I hope not, if you ever get "caught off guard" then you are doing something wrong and not paying the attention you should be. Nothing about this should ever be a "surprise", there is no excuse not to know what is coming. – GµårÐïåñ Oct 26 '17 at 18:00
@ GµårÐïåñ As I understand it, you are asserting that if you were required to make prepayments last year, and you did so, and you are required to make prepayments this year, and you don't, then there is no penalty, and dave_thompson_085 is asserting that this is false. – Acccumulation Oct 26 '17 at 18:46
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@GµårÐïåñ: in your example I believe you mean the case where you underpay this year only the amount your tax increased ("your circumstances change") and for that there is indeed no penalty. But your initial statement is too broad; there are other cases where you underpay for the first time and there is penalty. If you paid previous years and owe but don't pay this year, that's the first underpayment and there is penalty. If you paid previous years and owe at least as much this year but pay less than last year, that's the first underpayment and there is penalty. – dave_thompson_085 Oct 27 '17 at 03:11
@Acccumulation No I am making no such general assertion. The fact is that if you read the statute presented by the IRS, you can see when and where you are penalized (you knew you would owe but didn't pay enough) and when and where you are not as I have stated (your circumstances changed inconsistently and you are within limits of your exemptions). When in doubt, ask your own tax attorney and see what they say. – GµårÐïåñ Oct 27 '17 at 23:01
@dave_thompson_085 you are mixing different issues and lumping them in the same statement and that is incorrect way of going about it. I have no interest in trying to hold a tax seminar for everyone or argue the finer points which are expressly in the tax code and easily enough understandable by anyone who reads it carefully. As I have stated above, when in doubt, ask a lawyer or to a lesser reliability a tax preparer, I am relying on 20+ years of tax law knowledge as an auditor but heck what do I know. – GµårÐïåñ Oct 27 '17 at 23:05
@GµårÐïåñ First you said that the first time you underpay, you are not penalized. Then you say that if you knew you would owe you are penalized. Those are completely different claims. You said "the first time you have underpayment, there is no penalty", not "the first time you have underpayment, there is no penalty, as long as it's because your circumstances changed". – Acccumulation Oct 27 '17 at 23:13
@Acccumulation again, yes the first time you underpay when you have not paid taxes before and/or been required to pre-pay, you are not penalized. Or even when there are other conditions present, you won't be penalized. That's the end of it, go read and I won't reply again. – GµårÐïåñ Oct 27 '17 at 23:35
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@ GµårÐïåñ First you say that no one is penalized the first time. Then you say that you aren't saying that no one is penalized the first time. Then you say that no one is penalized the first time. Why are you bothering to comment if you have no desire to have anyone understand what you're saying? – Acccumulation Oct 29 '17 at 00:48

score 6 · Answer 2 · answered Oct 25 '17 at 15:12

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Your logic is not wrong. But the risk is more significant than you seem to assume. Essentially you are proposing taking a 2.6% loan to buy stocks.

Is that a good strategy? On average, probably. But if your stocks crash you might have significant liabilities.

In 1929, the Dow Jones dropped 89%. In 1989, >30%. In 2008-9, 54%. This is a huge risk if this is money that you owe in taxes. If you operate the same system year after year the chance of it going horribly wrong increases.

answered Oct 25 '17 at 15:12

Mark Perryman

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I agree if you're talking about only investing the amount you will owe in taxes, but I'm guessing that OP is proposing just adding your owed tax money to other, much larger existing investment accounts, then withdrawing the needed portion later. I feel that this would mitigate the risk significantly, although in a down year you will still pay a premium for needing to take out the money at tax time. – Wesley Marshall Oct 25 '17 at 15:39
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The key that I think the OP missed is just how bad a 'down year' can be. Plenty of people who thought they had more than enough have lost everything in crashes with leveraged investments. It could work for sure, but the potential downsides are not limited to those with "cash flow issues". – Mark Perryman Oct 25 '17 at 15:51

score 0 · Answer 3 · answered Oct 25 '17 at 15:23

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In addition to the other answers, which cover the risks of what is essentially leveraged investing, I'd like to point out that the 2.6% penalty is a flat rate. If you are responsible for withholding your own taxes then you are paying tax four times a year. So any underpayment on your first quarterly tax payment will have much more time to accrue in the stock market than your last payment, although each underpayment will be penalized by the 2.6%. It may make sense for someone to make full payments on later payments but underpay on earlier ones.

answered Oct 25 '17 at 15:23

Nosrac

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Actually the ~2.6% on 2016 Form 2210 is a 4% rate applied to a balance accumulating at the four quarters used by the IRC, see my comment to @HartCO on the Q. – dave_thompson_085 Oct 25 '17 at 20:14
Yes you are right, it is only a flat rate if you use the "short method" on the form. The "regular method" lower down does what you say. – Nosrac Oct 26 '17 at 12:31

MrMojo · Answer 4 · 2017-10-25T16:18:00.037

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"While the US tax code does not directly impose an obligation to pay estimated taxes, it does impose a penalty on individuals for failure to pay enough taxes either through withholding or estimated tax." USMTG

Anyone can choose how s/he wants to pay their taxes but they better deal with any consequences of not paying them instead of just complaining about it like most people do.

Most people get the hatred towards the IRS but most complaints are misdirected and should be directed towards Congress who creates and messes around with the US Tax Code.

Some people actually do not make estimated payments and pay any possible taxes with their returns knowing that there may be underpayment penalty. For those people, the penalty is relatively small compared to what they can do with the cash over a year's time (i.e. investing or paying down debt). It's their choice!

edited Oct 25 '17 at 16:18

answered Oct 25 '17 at 15:32

MrMojo

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This reads more like a rant against those who complain about paying taxes. Your 5th paragraph is the only one that comes close to answering the question. – Nosrac Oct 25 '17 at 15:52
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It may be a rant, but you can downvote the answer. Answering with a strong opinion doesn't qualify for a flag. – NL - Apologize to Monica Oct 25 '17 at 16:07
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@Nathan L: I'm not concerned about whether this post is strongly opinionated, I'm concerned about whether this answers the question. The question asks "does it make sense to delay payment of taxes?" and this answer's relevant content says "some people do delay paying taxes". – Nosrac Oct 25 '17 at 17:02
Does it make sense to delay payment of taxes? That is entirely a "subjective Choice" which is the point. At least people should be informed of why estimated tax should/not be made then let them make their choice. Isn't that the reason for the forums? – MrMojo Oct 25 '17 at 17:04
@Nosrac, the answer says why some people delay paying taxes: "The penalty is relatively small compared to what they can do with [it]". There's nothing wrong with that. – NL - Apologize to Monica Oct 25 '17 at 17:08
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It is true that there is no right answer, though a useful answer in this case would inform others about the benefits and disadvantages of delaying taxes so that they can make a choice. This answer adds nothing not already covered by other answers. – Nosrac Oct 25 '17 at 17:17

Why pay estimated taxes?

4 Answers4