Mullooly Asset Management
Fiduciary Fee-Only Financial Planner | Investment Advisor in Wall, NJ
Mullooly Asset Management
Tax Underpayment Penalties
Could rising tax penalties derail your retirement plans? Join us in this episode as we tackle the significant rise in tax penalties facing millions of filers and uncover the reasons behind this surge. We’ll unpack the intricacies of tax withholding and the importance of quarterly estimates, especially as you transition into retirement. With a focus on healthcare and insurance, we emphasize the critical need for thorough planning to safeguard your financial future.
We also explore the impact of rising interest rates and the resulting increase in taxable interest income from bank accounts and CDs. Learn how to manage this newfound taxable income and avoid penalties through careful planning. We delve into the complexities of "phantom income" from reinvested dividends and the challenges of capital gains management. By comparing brokerage assets and retirement accounts, we highlight the necessity of understanding different tax treatments to optimize retirement planning and income management.
Navigating retirement account distributions and understanding tax withholdings from various income sources, such as pensions, annuities, Social Security, and capital gains, can be daunting. We discuss how to coordinate these income streams to avoid underpayment penalties and benefit from a comprehensive financial overview. For self-employed individuals, LLC owners, and those with mixed income sources, we emphasize the importance of meticulous tax planning to ensure accurate withholdings. Lastly, Tom Malooly provides valuable insights into investment strategies, highlighting the importance of personalized financial advice to help you make informed decisions tailored to your unique needs and circumstances.
Welcome back to the Malooly Asset Management Podcast. This is Brendan Malooly, joined by Tom and Tim today, and this is episode 480, right guys?
Speaker 2:Yes, it is Correct, Host Brendan Malooly.
Speaker 1:Yeah yeah, gonna try to bring us through a pleasant topic today, of course, with taxes.
Speaker 2:Always, always pleasant.
Speaker 1:Ben Franklin, who said that the only constants in life are death and taxes, or something along those lines, right?
Speaker 2:Yeah, death taxes and the Mets winning on opening day. I'm just kidding.
Speaker 1:Well, I think when he said that about taxes, he forgot about the penalties that you can also owe on taxes.
Speaker 4:I think it's interesting that Ben Franklin talked about death and taxes and the IRS hadn't even been established yet.
Speaker 1:Yeah, he was referring to, I guess the Constitution had just been ratified. I think was what that was in regard to. But yeah taxes have been the bane of all of our existence, since the beginning of this country. I mean, that's kind of part of the reason, at least, why it was founded to begin with.
Speaker 2:Yeah.
Speaker 1:Taxation without representation.
Speaker 2:Yeah.
Speaker 1:But no need for a history lesson. I guess the point was we wanted to get to tax penalties, because I think everybody understands that we owe tax when we have income, but not everybody understands that we can also owe penalty on that tax if we don't withhold it and pay it at the appropriate time. So there was a Wall Street Journal article that reported that both the number of filers and the amount of those filers paying tax penalties has risen over the last few years. The estimates were, year over year, up from 12 million filers impacted to 14 million, as well as an estimated $7 billion in tax penalty owed, up from $1.8 billion.
Speaker 4:That is an astonishing number $7 billion in penalties and that it's gone from a number under $2 billion to now over $7 billion in just a couple of years.
Speaker 2:Yeah, that's a quick escalation. So clearly people are not doing things properly in terms of being properly withheld on their taxes or paying things like quarterly estimates at the right time, or underpaying. So it's interesting to see or to think about why it might be happening now at this point, but I think it's important to understand how all of that works in general.
Speaker 4:I got to admit I did not know. I said this before the mic was turned on. I did not know that there was a formula for calculating what the penalty, the underpayment penalty, would be. But it turns out that it's the rate on short-term treasuries plus three points Right.
Speaker 1:So those rates are around 8% now, which is a large factor in at least the amount being higher, but also the number of people being impacted by it suggests that there's more to it.
Speaker 1:And that's probably more along the lines of what Tim had mentioned in terms of people either not keeping track of these income sources well or not adjusting withholdings to account for different factors that can. That can make your taxable income higher in any given year. So, and I think that's that's a good uh, a good segue to, I think, what is an underappreciated aspect of the retirement transition that we help a lot of folks with, which is not just replacing their income but also replacing their tax mechanism, because most people earn an income from employment and have their taxes withheld as a part of that, and so it's not only the income we're replacing when we're making retirement plans, but also considering how to get the taxes withheld too.
Speaker 2:Yeah, I think a big part of that and, like the exercise that we go through for people, one of the more valuable points is getting you know we're trying to figure out how much money they need per year in retirement and we get to a gross number. But then we have to, you know, whittle that down to a net number. But then we have to, you know, whittle that down to a net number. And it's sometimes eye-opening to explain to people that you need to account for taxes even in retirement, because whether it's something like social security or pension income or even just selling investments in a brokerage account, there are capital gains taxes, not just regular income taxes, and then money coming from retirement plans that's being taxed on the way out, unless it was Roth dollars. So, like all of that put together, you need to still be properly withheld through retirement, like that part doesn't just end when you stop earning your normal salary.
Speaker 4:Would you say that not factoring in taxes is one of the larger oversights that people, one of the missteps that people make when they're trying to plan out their retirement?
Speaker 1:That and healthcare and interestingly enough, healthcare is another thing that is often attached to employment and therefore income, so that that trio of hey we got to replace the income, but also, like what things have been attached to the income that you're forgetting about here? And that's taxes and insurance beyond it. So yeah, it is one of the biggest things that is overlooked.
Speaker 4:I would say People see their net pay in their paycheck overlooked, I would say. People see their net pay in their paycheck. They're not even considering. Hey, I had money taken out for Social Security, for disability, for Medicare, but also your federal and your state income taxes.
Speaker 1:They're just not even thinking about it because it happens automatically with their payroll and you can recreate that system. But I think, as Tim alluded to, depending on the source of the income, you have some choices to make in terms of how you arrive at not only what your taxable income will be, but, I guess, how you withhold and then get that money to the IRS altogether, because you know, I guess, a good problem to have, because if you're diversified enough to have these choices to make, that's a good thing you want to have different options at your disposal in terms of tax status of your assets and being diverse there whether it be, you know, banks versus brokerage accounts versus retirement accounts versus social security All of those things are taxed differently. So maybe thinking through what some of these common sources are, talking it through, would be helpful for listeners. In terms of common sources of income, we see their taxability and their withholdability, because you can't withhold on all of these different types of income, which is what makes it so complicated, I think Right.
Speaker 4:Let's dig into the list.
Speaker 1:Yeah, I have a list here. Maybe we can just touch briefly on some of these, but for starters, interest and dividend income.
Speaker 2:I mean that's not really something that you can withhold on ahead of time. A lot of times you know, you could see what a company has paid out in dividends or you know historically, but that can change at any given time and you can't really withhold that ahead of time you have to. Yeah, exactly, and you can't just bypass it. It needs to be considered, so can't withhold for it, but definitely needs to be accounted for.
Speaker 4:I also think that a lot of folks are getting caught flat-footed because for about 15 years, from 2008 through a year or two ago, they earned nothing at the bank. And so they didn't have any interest.
Speaker 1:They may not have even had a 1099 issued if it was below the de minimis threshold. Now they're getting a 1099, you know, even for just a healthy emergency fund that might be a couple thousand dollars a year of interest. That's taxable as ordinary income if we're talking a bank account and I actually thought when I was reading about the increase in tax penalties that that might be one of the biggest sources of it.
Speaker 2:People not reporting the interest on just their savings accounts?
Speaker 1:Yeah, or people that have been gung-ho about things like CDs over the last 12 to 18 months now, with rates where they are not remembering that that is taxable income and so you know yeah, it's not just free money.
Speaker 2:You know, like the, I feel like people have gotten very like. You said gung-ho about wanting to. You know I can get four or five percent at the bank now or in a cd. It's like that's true, but like you have to, what's the? After tax. Exactly so it's. It's not. Uh, just, you know you, you get that money and you get to keep all of it.
Speaker 1:You know the government wouldn't do that if it's significant enough it can throw off, like you could nail the rest of your withholdings. And if you don't account for that and you're in your withholding estimates, you could be off by enough that you're in a position where then the irs is recommending estimated payments for the year ahead and then if you don't make those you could end up with tax penalties, like we began talking about.
Speaker 2:It's like a big puzzle piece and they're all different sized pieces, but they all fit together and it's your job to kind of assemble it. They don't really give you the instructions necessarily, or they give you the instructions, but they're in a different language. You know what I mean.
Speaker 4:It's not as straightforward as some people would like A lot of people I would say probably most people don't make the accounting entry to say I have to slice some of the interest off of my CD to send it in for quarterly withholding. They pay it out of some other source. Likewise, if you're reinvesting dividends, you don't have that dividend. Yeah, it's going to be taxable to you in a taxable brokerage account, but you still have to account for it.
Speaker 2:Yeah, I mean the term is phantom income. You recognize that income on your taxes, but it doesn't actually hit your bank account in cash form. It goes back into your investments. I feel like a lot of people may not account for that.
Speaker 1:Right. So dividends and interest taxable? Yes, and that's even a complicated answer when it comes to qualified dividends or not. Maybe we'll save that for another podcast entirely. But so taxable, yes, as most income sources are, but then also withholdable, no. So you have to incorporate that into your plan and see where you can possibly get it withheld.
Speaker 1:And see where you can possibly get it withheld. Get the money that you owe to the IRS in a timely fashion so you don't end up owing tax penalty on it. The next one that comes to mind is capital gains.
Speaker 2:Yeah, and I mean capital gains, whether they're short-term or long-term, they're taxed differently. But even long-term capital gains, which tend to be lower than short term capital gains, you know they're still definitely taxable, so it's. I don't know if you could say that you can really withhold for them ahead of time. You know, like you can kind of again like mentally factor it in when you're looking at your after-tax return.
Speaker 2:You can like kind of physically separate it if you, if you want to, or just mentally account for it off to the side, but it's not really something that's like built in withholdable yeah so with non-automated, with thinking like easily, easily automated, uh, done for you, so you not like a paycheck withholding you have to make some kind of book entry item for that.
Speaker 1:And to avoid a tax penalty. If you have a big capital gain that you recognize, the estimated payment should be done in the quarter that the income is recognized. Otherwise there's going to be a penalty owed on it.
Speaker 2:Yeah, I think that's. Another part that people miss sometimes is the timing of things like quarterly estimates.
Speaker 1:So you can make up for not sending in an estimated payment on income recognized like this with other sources of automated withholding that gets sent to the IRS. But that was in the article from the Wall Street Journal. They were talking about the timing of getting the income there and how there's a tax form to file in the event that there's a timing mismatch in terms of when the payment was made, when the gain was recognized. But when we're talking capital gains, we could be talking about stuff done in a brokerage account. We could be talking about selling real estate. There are a variety of ways you could get to a capital gain and it isn't something that gets withheld in the transaction and often that is a point of confusion for folks if they're calling up for you know money from an account and they're used to withholding on on the transaction like you can on a retirement account right say you can't do that from a brokerage account, but it doesn't mean the transaction isn't taxable.
Speaker 1:that depends on what you've sold and how long you've held it, so a little complicated, but it's good to have these two buckets. Now that we've talked about in terms of these would come from you brokerage assets from a bank account, it's good to have those in conjunction with these other sources where they are a little more withholdable Right.
Speaker 2:Yeah yeah, I think the brokerage assets the capital gain taxed assets versus the retirement assets is an important point for people in their retirement planning, income planning, because they're taxed at different rates. We could probably do another short podcast on that, but there are different tax brackets for long-term capital gains and ordinary income tax brackets. So trying to figure out the balance of that whether you want to go fully retirement assets or banked and brokerage assets, the capital gains assets or a combination of the two that can be an important exercise for some people too.
Speaker 1:Yeah, so maybe on to the sources where you do have that optionality and I would put it as optionality because you never have to withhold from any of these sources, but you have the ability to withhold as you go and have money sent directly to the IRS on your behalf. This would include stuff like your Social Security, which often comes as a surprise to people that it's taxable to begin with.
Speaker 2:Yeah.
Speaker 1:Taxable and withholdable, although interesting with Social Security in the sense that you can only withhold the set percentages that are offered on the withholding form, the W-4V, I think, is the one for Social Security.
Speaker 4:That's right.
Speaker 1:Flat percentages there, and then you have pension or annuity income and then distributions from retirement accounts.
Speaker 2:Yep, pension or annuity income, and then distributions from retirement accounts. Yeah, the Social Security one, I think, is sometimes an eye-opener for folks. So you get that number of what you can expect from Social Security and then net out taxes and if things like your Medicare premiums are being taken from that, the physical check that hits your bank account each month could end up being a lot less than what you were expecting.
Speaker 1:And important to account for all of those in their own way. Again, you don't have to withhold anything on it, but if you're not withholding from there, you're either going to have to make estimated payments or withhold from another source, because you're going to owe tax on the money, whether you choose to withhold on it or not.
Speaker 2:Right.
Speaker 1:A lot of cases, stuff like Social Security or pension income or annuity income. We come across folks that already have this stuff in place, being withheld at whatever rate felt appropriate when it began, and what they're trying to do as their plan progresses into retirement is supplement from other investment sources and and so what? What you're then doing is trying to connect the dots behind the scenes in terms of hey, maybe this, maybe this Social Security income is being withheld, maybe it's under withheld. How?
Speaker 2:do you make up the?
Speaker 1:difference from an estimated payment or or retirement distribution. To make sure that they're tracking well, to not owe money.
Speaker 2:Ideally it's like let's say, your tax bracket is 20%, you could cleanly withhold 20% across the board from all these different sources, but it usually never works out that way. The board from all these different sources, but it usually never works out that way. So if one of your sources of income is being withheld at 10%, you have to make up the difference from something like a retirement account or some other source of income to get up to that 20% number that you need to hit. So it's an interesting calculation or something to look at that I don't know people don't consider sometimes.
Speaker 4:Apparently 14 million people didn't consider it last year.
Speaker 1:Yeah, Right, I think with the retirement account distributions they end up being, in a lot of cases, the most flexible or easiest to alter. You can absolutely change your withholdings on stuff like pension income or annuity income. It usually involves sending in some kind of a W-4 to the provider of that, whether it be the Social Security Administration or annuity provider, pension provider, and in a lot of cases different investment custodians are just easier to work with in that sense. And so we often find ourselves in the role of working to determine what would be reasonable to withhold on a retirement account distribution, to kind of bring all the other sources together, whether it be coordinating capital gains that were recognized in that calendar year in a brokerage account or other income sources like pension, social Security, to kind of bring the withholding all home. And that is a pretty simple way to do it.
Speaker 4:Yeah, I think it's a somewhat awkward conversation to have with a client when you find out that last year they had an underpayment penalty because that could be avoided if we had more information. Where all the sources are, all the sources of income. What's been withheld, what can we do about it so that this doesn't happen again in the future?
Speaker 2:Yeah, I think that's an important part of why, when we start working with people, we try and get as much info for the entire picture all the income sources. Fill out their cash flow and the balance sheet to really get an idea of all the different income sources. Sometimes people come to us and they just want us to manage a certain account for them and it's like you know, setting aside the fact that it would be difficult for us to properly invest the money for them things like this we can't really consider any sort of tax picture for you because we don't know what's being withheld on other types of assets that you have as well.
Speaker 1:The taxes end up being a thing that people don't understand in a lot of cases, where they get them done every year and sometimes they owe and sometimes they don't, and and not understanding the reasons why. Behind behind that is is what seems to be a kind of a gap in the knowledge for a lot of people. And so just being able to consider all the sources, see, you know what withholding is going on and and, maybe, uh, you know, bring it, bring it all together for people is is a good way to, I think, be fiduciary and be thorough and to make it it doesn't have to be a mystery Like it. I can appreciate the idea that the uh IRS doesn't make it like very easy to understand but, um, you know, to the extent that we can, if we have all the info, we can kind of play interpreter to clients and solve some of those problems for them If they found themselves chronically under withheld or over withheld or owing penalties, things like that. It's usually just not considering all the information and putting it all together.
Speaker 2:Yeah, yeah, I think also the conversation here is kind of seemed to be centered around retirement income and people in retirement, but this kind of thing applies to people at any phase of life, whether W-2 income versus 1099 income as well. Like if you're, if you're on your own on you know, if you, if you don't have the w-2 income, that's being automatically withheld and you're self-employed or you know you get a 1099 from somebody, that might be that gross amount and you have to mentally set aside the money. Or you could have both sources of income. You have two different jobs where you're a contractor and you get 1099 income and then you also have a salary job where you get W-2. And trying to piece those two together to come out to your proper withholding can sometimes be difficult for people.
Speaker 4:One of the things that we can lump in with this is the LLC owner, who has maybe not taken a paycheck, but takes a draw each year and then has to calculate not only the tax on it, but when did I earn it and what do I owe on it. It's a big problem.
Speaker 1:That's got to be a pretty big source of the underpayment penalties because, especially if you have an uneven income, you're most likely, when you file the prior year taxes, if you owe money or if you're doing self-employment, you're going to get estimated payment vouchers that you should make.
Speaker 1:But those are guesses based on last year's income and if you're not in real time reflecting on what kind of income that you've realized during the current calendar quarter that you're paying for in the year ahead, then you find yourself in a position where you may owe penalties and you could do all of the best work and even have a W-2 job, to Tim's point. But if you're trading stocks or something and you made a bunch of money, that's great.
Speaker 1:But again you have to calculate your after tax return on that because that is, you know, you only keep what you keep, so I think the taxes factor into that too. It's a little bit complex in the sense that even the withholdable sources of income bit complex in the sense that even the withholdable sources of income, you have to know your numbers and do that correctly. But these additional ones, whether it be self-employment or things like capital gains or interest income, these are the things that don't get considered and you really have to have kind of a global view to take a look at all this and make sure that you're square come tax time, or else you're going to be one of the $14 million now who ends up owing taxes and maybe penalties too, which is an unfortunate situation to find yourself in. That's a good place to wrap up, I think. So thanks again for tuning in to episode 480, and we will see you on the next one.
Speaker 3:Tom Malooly is an investment advisor representative with Malooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Malooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Malooly Asset Management may maintain positions and securities discussed in this podcast.