Estimated Taxes, Safe Harbor, and AMT

[This is part of a series of posts on the home buying process I'm going thru. To see the full set, visit the house category archives.]

In the comments for my earlier post on the matter, someone asked if I had $100,000 in the bank for a down payment.

No, not quite. Much of it is invested. To come up with a down payment, I'll need to sell off a fair amount of stock and/or cash in some stock options. These sales will not be classified as long term capital gains. They'll be short term gains, which means they are counted as income for tax purposes. And that means my taxable income will be quite a bit higher than it has ever been.

Given the greedy, unfair nature of our screwed up government, that may spell trouble in a couple important ways.

Estimated Taxes

Normally, my employer withholds money from my paychecks to cover my tax liability. However, if they don't withhold enough money, I may be forced to pay estimated taxes. That is, I'll have to guess how much I'm likely to owe and send a check to the IRS on a quarterly basis to cover my ass.

Why might my employer not withhold sufficient tax money? They may not know about all my sources of income (such as the book and the magazine articles and the consulting and so on). So they may conclude that I belong in one tax bracket when I really belong in a higher one. Or maybe I'll incur significant gains from investments that they don't know about.

Either way, if I end up paying less than 90% of what I really owe to the government, I may be subject to fees and penalties unless I pay estimated taxes.

One simple solution is to contact the payroll department and adjust my W-4 Form a bit. I can instruct them to withhold additional money from every paycheck for tax purposes. I did this on Wednesday.

For more reading on the issue, see Paying Estimated Taxes from the Motley Fool. You may also want to see the Fairmark Press Guide to Estimated Taxes.

Safe Harbor

There's a catch or two.

I'll just quote the Motley Fool rather than explaining it myself.

If this is the first year that your income has spiked or otherwise increased substantially, you still might not have to pay estimated taxes and might be able to pay the entire balance due on April 15 without penalty by using the so-called "exception #1." Essentially, if your current year's withholding is at least as much as your previous year's total tax (assuming that your AGI for the prior year is $150,000 or less), you can ignore any increases in 2002 income and pay any balance due with the tax return on April 15 without penalty.

And even then there's a follow-up catch:

If you can't get out of paying estimated taxes, there's a convenience you need to know about: the "safe harbor." For the average person, this means that as long as you pay 100% of your previous year's total tax liability in withholding and/or estimated taxes, you'll be free from any penalty for underpayment of estimated tax, no matter what the current year's taxes end up being. So if your tax liability was $12,000 last year, but this year you expect to sell some stock and have substantially higher taxes to pay, you'll probably have to pay estimated taxes. But you can use the safe harbor and just make sure that you pay at least $12,000 in estimated (or withheld) taxes.

What this all means is that I may not have to worry about paying the extra taxes until April 15th of next year. But that really depends on my 2003 tax returns, which I haven't quite figured yet.

Fun, isn't it?

Wait, it gets "better"...

The Alternative Minimum Tax (AMT)

As if the government isn't raping me badly enough, there's a provision in the tax code known as AMT. The idea is to provide a separate, parallel set of tax rules that take over in situations when the government feels that the normal rules haven't quite raped you hard enough.

The rules are actually quite complicated, but in a nutshell there are a few things that tend to trigger AMT:

• Exemptions
• The Standard Deduction
• State and Local Taxes
• Interest on a Second Mortgage
• Medical Expenses
• Miscellaneous Itemized Deductions
• Credits
• Incentive Stock Options (ISOs)
• Long-Term Capital Gains
• Tax-Exempt Interest
• Tax Shelters

For more reading on the subject, I recommend the Fairmark Press Guide to Alternative Minimum Tax (AMT). It's a fair amount more detailed that what the Fools provide. It covers:

• Alternative Minimum Tax 101
• Top 10 Things that Cause AMT Liability
• AMT and Long-Term Capital Gain
• Dual Basis Assets

As you'll see, it's sorta complicated.

Finding Help

The smart move is to find a tax professional who understands all the nuances of the tax code and how the laws may apply to my situation(s). So this week I contacted someone based on a recommendation from a co-worker. (See, it's my social network in action again.)

After we've had a chance to meet and go over some details, I'll post a recommendation here if I think he's doing a good job for me.

Posted by jzawodn at January 10, 2004 09:49 AM