Once upon a time there was a small business owner named Goldilocks. She owned a business in the woods. As a small business owner, she was subject to self employment tax and was required to make estimated payments.
One day an ill-informed tax preparer knocked on her door. The taxman told Goldilocks that she need not be concerned about making her estimated payments to the IRS. Goldilocks loved the idea and followed his advice to the letter. All year long, her business made money and grew, and all year Goldilocks neglected the pay- as –you-go tax system and lived happily spending the money she earned.
The pay-as –you-go tax system was established for those who are self employed. Each quarter the IRS requires an estimated tax payment for the tax due on income. Neglecting these payments may result in an underpayment penalty at tax time!
Goldilocks enjoyed the fruits of her labor throughout winter, but then spring arrived. Goldilocks was shocked when she learned that she had a huge tax bill due, including an underpayment penalty. Goldilocks thought her prior year’s tax planning was “too cold” and decided to revisit the estimated payment idea.
A few weeks later, an over-anxious tax preparer arrived at her door. This conservative preparer told Goldi to send big chunks of her income into the IRS. While Goldi slept a little better at night, her disposable income was negatively affected…..she didn’t have money to spend.
After a year of this method, Goldilocks completed her tax return and learned she was due a huge refund. While the idea of a large refund made her happy, she realized the money she paid to the IRS was being returned to her without any interest. She thought this method was “too hot!”
Any money paid into the IRS and then returned to the taxpayer will be returned without interest. In essence, overpayments are equivalent to an interest free loan to the government, so large refunds are not always the most efficient use of hard earned money.
Goldilocks was upset that she mishandled her taxes the last two tax years. She didn’t know what to do. While sitting and thinking about her options, a new tax preparer appeared at the door. This preparer sat down with Goldilocks and discussed her situation. They talked about her income and expenses and created a projection of her current year’s tax liability. This projection was used to determine the estimated tax payments Goldilocks needed to pay for her current tax year.
After a year of pro-active tax planning, Goldilocks was excited to see that at tax time her estimated payments were not “too hot” or “too cold”….they were “just right”!
Moral of the Story
It is important not to over or under pay estimated tax payments. Merely taking a guess can create a bad situation. Underpayment penalties really are easily resolved through proper planning. Overpayments are not the answer either, because no one wants to give the government a big interest free loan. Creating a balance between tax payments and retaining liquidity for current cash flow is truly the Goldilocks’ scenario in which tax planning is “just right.”