My investment accounts do not have any taxes withheld from my capital gains, so I will owe large amounts of money when I file my tax return. How can I alleviate this situation?
-David
Because capital gains distributions are unpredictable and typically unknown until the end of the year, they can be difficult to plan for. Taking proactive steps to anticipate your tax bill and pay it in advance can help you avoid an unmanageable balance in April.
Read on to learn more about how to manage your tax debt 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 to pay taxes all year long instead of facing a huge tax bill in April: adding or increasing withholding taxes from another source of income, or making estimated tax payments quarterly.
A third possible option would be to contact the mutual fund generating the capital gains distributions directly and ask them about the withholding. It’s possible the company could facilitate that, but that’s not likely. As for your investment account, these institutions typically only offer deductions if you sell securities or take distributions into your retirement account.
Keep in mind 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) contain 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 sales proceeds to each investor – that’s a capital gains distribution.
As an investor, you usually don’t know what to expect in terms of capital gains income until late in 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 come into play when you sell an investment for more than the purchase price, you haven’t taken any action here. The distribution of your capital gains is purely the result of transactions carried out by the fund itself. So even if you haven’t sold any shares of your mutual fund, you will have taxable income from those capital gains distributions.
This income is taxed like long-term capital gains, regardless of how long you have actually owned your fund’s shares. Long-term capital gains tax rates are based on your total taxable income and filing status. This income is therefore taxed at 0%, 15% or 20%.
How can I deal with these taxes?
Because you won’t know how much you might receive in capital gains distributions until late in the year, it can be difficult to estimate your tax bill precisely, but you can get close enough to at least avoid underpayment penalties 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 prior year’s tax bill, or owe less than $1,000, you can avoid being charged underpayment penalties will be charged, even if you ultimately owe a fine. .
Both methods ask you to have a good idea of your annual income early in the year, which isn’t always practical. You can start with your best estimate and make adjustments as necessary throughout the year. (Need help with a financial question? This tool can help match you with potential advisors.)
Start or increase withholding from 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 request a deduction from Social Security payments.
If you have an online account for your other source of income, you can probably request or change withholding taxes there. You fill out a Form W-4 (or its equivalent) and enter the amount you want to withhold on the line that says “additional withholding.” For government payments such as Social Security, 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 approximately how much tax you owe, you can divide that by four and make an equal estimated tax payment each quarter. You can complete IRS Form 1040-ES and mail it along with a check to your designated IRS mailing center, or make your payment online at the IRS website. If you pay online, make sure you choose ‘Estimated Tax’ with the reason and the correct current tax year.
Pro tip: When making estimated tax payments on a jointly filed tax return, be sure to use the Social Security Number of whichever of you is listed first on the tax return (as “taxpayer” rather than as “spouse”). The IRS system sometimes misapplies or does not apply payments correctly when the other SSN is used.
Estimated payments by tax due date are:
Estimated tax payments versus withholding taxes
Keep in mind that there are more potential penalties associated with estimated tax payments than withholding taxes. It’s also a lot easier to manage deductions because you can set them and forget them, rather than remembering to proactively make a payment 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 large tax bill in April. You can withhold additional taxes from another source of income or make an estimated quarterly tax payment. Either way, you’ll spread your taxes out over the entire year instead of coming up with a lump sum on your tax return.
Find a financial advisor
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If you have questions specifically related to your investment and tax situation, a financial advisor can help you. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving 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, get started now.
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Understanding your tax bill can help you plan for your money. Whether you plan to save for retirement, pay off your student or credit card debt, or otherwise invest your money, SmartAsset’s tax return calculator can help you figure out how much you’ll get back from the government so you can get ahead can plan.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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Michele Cagan, CPAis a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that 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 SmartAsset AMP platform, is not an employee of SmartAsset, and has received compensation for this article.
Photo credits: ©iStock.com/Milan_Jovic, ©iStock.com/AmnajKhetsamtip
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