No taxes are withheld from my capital gains in my investment accounts, causing me to owe large amounts when I file my tax return. How can I defuse this situation?
-David
As Capital Gains Distributions are unpredictable and usually unknown by the end of the year, they can be difficult to plan for properly. If you take proactive steps to anticipate and “pay upfront” your tax bill, you can avoid an unmanageable amount due in April.
Read on for more information on how to manage your tax liability throughout the year. (Need help with a financial question? This tool can help match you with potential advisors.)
Options to prepay your tax bill
You have two main options for paying taxes year-round instead of dealing with a huge tax bill in April: add or rising withholding taxes from another source of income or through quarterly estimated tax payments.
A third possible option would be to contact the mutual fund generating the capital gains distributions directly and ask them for a withholding. It’s possible the company would make this possible, but not likely. As for your investment account, these institutions usually only offer withholding tax if you sell securities or receive distributions from your retirement account.
Be aware that using these strategies will reduce the balance you have to pay when filing your taxes. But they won’t reduce your actual tax bill. (Need help with a financial question? This tool can help match you with potential advisors.)
What are capital gains distributions?
mutual funds and Exchange Traded Funds (ETFs) Hold lots of underlying assets like stocks and bonds. During the year they may sell some of these investments resulting in capital gains or losses within the fund. At the end of the year, the fund distributes a proportionate share of these sales proceeds to each investor – this is a capital gains distribution.
As an investor, you usually don’t know what to expect in terms of income from the capital gains distribution until the end of the year. Funds usually post information about estimated payouts and expected payout dates on their websites in November or December.
Unlike normal capital gains, which come into play when you sell an investment for more than its purchase price, you haven’t taken any action here. Your capital gains distribution is solely the result of trades made by the fund itself. So even though you haven’t sold any shares in your mutual fund, you still have taxable income from those capital gains distributions.
This income is taxed as is long-term capital gains, no matter how long you have owned your fund shares. Long-term capital gains tax rates are based on your total taxable income and filing status, so that income is taxed at either 0%, 15% or 20%.
How can I deal with these taxes?
Since you don’t know by the end of the year how much capital gains distributions you might receive, it can be difficult to estimate the tax bill accurately — but you can get close enough to at least avoid IRS penalties for underpayments. The IRS has safe harbor guidelines: As long as you pay at least 90% of your current tax bill, 100% of the prior year’s tax bill, or owe less than $1,000, you can avoid being billed for underpayment penalties, even if you do you have debts .
Either method requires you to have a good sense of what your annual income will be early in the year, which isn’t always practical. You can start with your best guess and make adjustments as needed throughout the year. (Need help with a financial question? This tool can help match you with potential advisors.)
Start or increase withholding taxes on other income
If you have other sources of income, such as B. a regular W-2 job or federal pension income, you can require them to withhold enough withholding to cover this additional income. You can even apply for withholding of Social Security payments.
If you have an online account for your other source of income, you can probably claim or change the withholding tax right there. You fill out a Form W-4 (or equivalent) and enter the amount you wish to withhold on the “additional withholding tax” line. For government payments like Social Security, use Form W-4V and select the percentage you want to withhold. You can also opt out of this retention at any time by updating your choices.
Make quarterly estimated tax payments
Once you know roughly how much tax you owe, you can divide that by four and make the same estimated tax payments each quarter. You can either fill out IRS Form 1040-ES and mail it to your local IRS mailing center along with a check, or you can make your payment online at the IRS website. When paying online, make sure you select “Estimated Tax” as the reason and the correct current tax year.
Pro Tip: If you’re making estimated tax payments on a jointly filed tax return, be sure to use the social security number of whoever appears first on the tax return (as “taxpayer” and not “spouse”). The IRS system sometimes misapplies or misapplies payments when the other SSN is used.
Estimated tax payments on the due date are:
Estimated Tax Payments vs. Withholding Taxes
Note that estimated tax payments have more potential penalties than withholding taxes. It’s also a lot easier to manage withholding because you can set it and forget it, rather than having to think about making a payment proactively every quarter. (Need help with a financial question? This tool can help match you with potential advisors.)
Next Steps
There are two ways to avoid paying a hefty tax bill in April. You can withhold additional taxes on another source of income or make quarterly estimated tax payments. In any case, spread your taxes over the whole year instead of calculating a lump sum on your tax return.
Find a financial advisor
If you have questions about your investment and tax situation, a financial advisor help. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three verified financial advisors operating in your area, and you can interview your advisor matches for free to decide which one is right for you. When you are ready to find an advisor who can help you achieve your financial goals, get started now.
Understanding your tax bill can help you make plans for your money. Whether you’re saving for retirement, paying off college or credit card debt, or looking to invest your money elsewhere, SmartAsset’s tax return calculator can help you figure out how much you’ll get back from the government so you can plan ahead.
Michele Cagan, Chartered Accountant, is a SmartAsset financial planning columnist and answers readers’ questions on personal finance and tax topics. Do you have a question you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAdvisor Match platform and has been compensated for this article.
Photo credits: ©iStock.com/Milan_Jovic, ©iStock.com/AmnajKhetsamtip
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Source : finance.yahoo.com