I finally submitted our household’s 2020 taxes this week after dozens of hours of reading over papers and entering and double-checking data. If I were to print out the full bundle, including worksheets, it would take 774 pages, according to my tax software. The same software also tells me that the federal government owes us a small return. While it would be good to get our money back, I don’t think we’ll see anything in 2021. Instead, I’ve urged the government to put our overpayment from 2020 to our taxes in 2021. It’ll gladly comply with that request, which is why Uncle Sam is retaining my refund this year.
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Is this insane or what?
Our tax position is convoluted to say the least, with 774 pages of forms, schedules, and spreadsheets. The root of the problem is that we earn money in three ways: through traditional employment, small company ownership, and investing.
To make matters more complicated, some of that investment income comes from bonds and stock options. Expiration dates are associated to these types of investments. As a result, they mature and must account for capital gains and losses. This results in extra paperwork, which is why our tax returns have such a high page count.
Unfortunately, because of this intricacy, it’s difficult to predict what we’ll actually make (and owe) early in the year. The IRS does not expect you to get your taxes perfect before the end of the year, but it does want you to get close throughout the year and then correct them by the filing deadline. The decision to put our 2020 refund to our 2021 taxes stems from this need to get close.
If you get close enough, the safe harbor laws apply.
Before you file and true up by the filing date, the IRS uses three distinct tests to see if you’re “near enough” with the tax money it collects from you during the year. The safe harbor rules are those exams, and you only need to pass one of them per year to be regarded close enough. The tests are as follows:
If you pay within $1,000 of what you owe for the year, or if you pay at least 90% of what you owe for the year, or if you pay at least 100% of what you owed the previous year (110 percent if you’re considered high-income), you’ll be regarded in good standing.
Safe harbor protects you if you meet any of those requirements by making timely anticipated payments or withholdings. You’ll still have to file and true up the rest of what you owe by the filing deadline, but if you follow one of those three rules and true up the rest on time, you won’t be charged any underpayment penalties.
The primary problem with the first two guidelines is that meeting either of them requires a reasonable estimate of what you’ll owe for the year. If your income is erratic and subject to market fluctuations, this can be a difficult process. However, if you want to be deemed covered by the safe harbor, you know exactly how much you need to put in under the third rule.
It’s difficult to foresee the future.
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That third safe harbor rule is the one I focus on for our tax planning early in the calendar year because it’s the only one that can be predicted. I can adapt when reality sets in as the year progresses, but by starting out there, I won’t have to make any modifications throughout the year and will at least have a target to shoot for.
While our income in 2021 will be as unknown as it was in 2020, I have reason to anticipate it will be lower. We had two long-term one-time bonuses that matured and paid out in 2020, but none are set to mature and pay out in 2021. Unless the market makes us a series of offers we can’t refuse, our 2021 income will have a long way to go to catch up to the 2020s.
When we combine a lower predicted income with a tax payment plan based on last year’s greater income, we’re looking at a situation where our take-home pay could be severely impacted. That’s where allowing Uncle Sam to keep our 2020 refund appears to be beneficial. By transferring our 2020 refund to our 2021 taxes, we’ll have a lot less withheld in 2021 while still being covered by the safe harbor.
By foregoing our 2020 refund, we will receive a larger check every payday for the remainder of 2021. While we could have taken the refund check and utilized it to cover the increased withholdings we would have had to pay otherwise, savings account interest rates are approaching zero. As a result, the extra bother didn’t seem worth it for the pennies of interest that money would create if we retained it ourselves.
Find a way to get safe harbor protection for yourself.
While it is the safe harbor test I use to try to stay out of trouble with the IRS, it isn’t the only way to do so. Instead, you can pay enough and timely quarterly estimated taxes. You can also have money withheld on an alternative timetable that meets at least one of the safe harbor requirements. Following a different method in years where you expect your tax liability to be lower than the previous year could allow you to keep more of your money in your pocket throughout the year.
The main trade-off you’ll have to make is that alternative methods of staying under the IRS’s safe harbor rules necessitate greater vigilance. You’ll need to get close to what you owe for the current tax year to pass either of the other two safe harbor criteria. That implies that if your tax liability grows over the year above what you anticipated, you’ll have to increase the amount you send Uncle Sam to stay protected. It’s possible to make it work, but you’ll need to be more organized throughout the year.
“In this world, nothing is certain but death and taxes,” as Benjamin Franklin famously observed. Make sure you expect to be covered by one of the safe harbor tests as you finish up your 2020 taxes and set yourself up for success in 2021. That way, when you settle up, all you’ll owe is your tax burden, and you won’t be penalized for not keeping track throughout the year. Continue reading
