My investment accounts do not withhold tax on my capital gains, causing me to owe large sums when I file my returns. How can I remedy this situation?
-David
Since capital gains distributions are unpredictable and generally unknown until the end of the year, it can be difficult to time them well. Taking proactive steps to anticipate and “prepay” your tax bill can help you avoid an unmanageable balance due in April.
Read on for more information on how to manage your tax liability throughout the year. (Looking for help with a financial question? This tool can help you find potential advisors.)
Options to “prepay” your tax bill
You have two main options for paying taxes throughout the year rather than facing a huge tax bill in April: add or increase source deductions from another source of income, or make tax payments. estimated quarterly tax.
A third possible option would be to directly contact the mutual fund generating the capital gains distributions and ask about the withholding. It is possible that the company facilitates this, but unlikely. With respect to your investment account, these institutions generally only offer withholding tax when you sell securities or receive retirement account distributions.
Be aware that using these strategies will reduce the balance you have to pay when you file your taxes. But they won’t reduce your actual tax bill. (Looking for help with a financial question? This tool can help you find potential advisors.)
What are capital gains distributions?
Mutual funds and exchange-traded funds (ETFs) hold many underlying investments such as 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 the sale proceeds to each investor – this is a capital gains distribution.
As an investor, you generally won’t know what to expect in terms of capital gains distribution income until the end of the year. Funds typically post information about estimated distributions and expected payout dates on their websites in November or December.
Unlike regular capital gains, which kick in when you sell an investment for more than you bought it, you haven’t taken any action here. Your capital gains distribution is purely the result of transactions made by the fund itself. So even if you haven’t sold any shares of your mutual fund, you will have taxable income from these capital gains distributions.
This income will be taxed as a long-term capital gain, regardless of how long you actually hold the units of your fund. Long-term capital gains tax rates are based on your overall taxable income and filing status, so that income will be taxed at 0%, 15%, or 20%.
How can I manage these taxes?
Since you won’t know until the end of the year how much you might receive in capital gains distributions, it can be difficult to estimate the exact tax bill – but you can get close enough to at least avoid penalties. underpayment from the IRS. The IRS has safe harbor guidelines: as long as you pay at least 90% of your current tax bill or 100% of the previous year’s tax bill, or you owe less than 1 $000, you can avoid being charged underpayment penalties, even if you end up owing .
Both methods require you to have a good idea of what your annual income will be at the start of the year, which is not always practical. You can start with your best estimate and make adjustments during the year if necessary. (Looking for help with a financial question? This tool can help you find potential advisors.)
Start or increase withholding on other income
If you have other sources of income, such as a regular W-2 job or federal retirement income, you can request that they withhold enough taxes to cover this additional income. You can even claim a withholding tax on Social Security payments.
If you have an online account for your other source of income, you can probably request or change source deductions on the spot. You will fill out a W-4 form (or equivalent) and enter the amount you want to withhold on the line that says “additional withholding.” For government payments like Social Security, you’ll use Form W-4V and choose the percentage you want to withhold. You can also stop this hold at any time by updating your choices.
Make quarterly estimated tax payments
Once you know the approximate amount of tax you will have to pay, you can divide it by four and make equal estimated tax payments each quarter. You can either complete IRS Form 1040-ES and mail it with a check to your designated IRS mailing center or make your payment online at the IRS website. If you are paying online, be sure to choose “Estimated Tax” for the reason and the correct current tax year.
Pro tip: When making estimated tax payments for a jointly filed tax return, be sure to use the social security number of whichever of you appears first on the tax return (as the “taxpayer”). rather than as “spouse”). The IRS system sometimes misapplies or does not apply payments correctly if the other SSN is used.
The estimated payments on the tax due date are:
Estimated Tax Payments vs. Withholding Taxes
Be aware that there are more potential penalties associated with estimated tax payments than withholding taxes. It’s also much easier to manage holdback because you can set it and forget it, instead of remembering to proactively make a payment every quarter. (Looking for help with a financial question? This tool can help you find potential advisors.)
Next steps
There are two ways to avoid paying a big tax bill in April. You can withhold additional taxes from another source of income or make estimated quarterly tax payments. Either way, you’ll spread your taxes over the entire year instead of coming up with a lump sum when you file your tax return.
Find a financial advisor
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If you have questions specific to your investment and tax situation, a financial advisor can help. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors who serve your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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Understanding your tax bill can help you plan for your money. Whether you’re planning to save for retirement, pay off college or credit card debt, or invest your money differently, SmartAsset’s tax return calculator can help you figure out how much you’ll receive from the government so you can plan ahead.
Michele Cagan, CPA, is a SmartAsset financial planning columnist and answers readers’ personal finance and tax questions. Do you have a question you would like answered? Email AskAnAdvisor@smartasset.com and your question might be answered in a future column.
Please note that Michele does not participate in the SmartAdvisor Match platform and was compensated for this article.
Photo credits: ©iStock.com/Milan_Jovic, ©iStock.com/AmnajKhetsamtip
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