Financial Q&A: How to avoid IRS penalties when estimating quarterly tax payments

Q:
I understand that on federal income taxes there is no penalty for underpayment if your estimated payments equal 90 percent of the tax due in the taxable year, or if the estimated payments total 110 percent of the tax you paid in the prior year. My question: Does the 110 percent 'safe harbor' rule pertain even if in the current year much of your taxable income came from one-time capital gains? In short, does it matter what the source of income is in applying the 110 percent safe-harbor provision?

S.S., via e-mail

A: Money is money to the IRS, according to Anne-Marie Fisher, director of tax services at CBIZ Accounting in Chicago. It doesn't matter what the source of income is for the 110 percent safe-harbor prior-year tax rule for underpayment penalty.

If a taxpayer incurs large capital gains one year and doesn't incur those gains in the following year, it would be a good idea, she says, to estimate your current year's income and pay 90 percent of the current year's tax if the current year's tax will be lower.

If the taxpayer doesn't know what next year's income will be, Ms. Fisher suggests that he or she may want to pay in the protective 110 percent estimate for the first two quarters and then look at how the first half of the year went and make adjustments for the remaining two estimated tax payments based on your current year's income (there are four payments altogether).

Q:
My employer offers to match up to 3 percent of my contributions to the company's 401(k) plan. Should I only contribute to the 401(k) up to the point it is matching and then contribute to my IRA? Or should I max out my 401(k) and then contribute to other investments?

K.P., via e-mail.

A: You need to contribute enough to your 401(k) to get the full match, says Gregory S. Ostrowski, a certified financial planner in Annapolis, Md.

If you're like most people, discipline is the greatest factor in saving, he says. Through payroll deduction, it's often easier to contribute to your 401(k) than other investments, and the major advantage is that there's no temptation to spend it.

Focus on maxing out your 401(k), says Mr. Ostrowski. Get into a comfortable routine, and then look toward other investments. An IRA can make sense if you're concerned about limited investment options inside your 401(k) or if your 401(k) does not have the recently introduced Roth provision. (Keep in mind that both Roths and traditional IRAs have income limits for anyone who participates in a 401(k) plan.)

Lastly, Ostrowski says that it's important to have the liquidity of a 3- to 6-month emergency fund. If all your money is in a 401(k) or an IRA, you may not have easy access to it if and when you need it.

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