As she stood at the mailbox, Suzanne's face went pale when she saw the return address: Department of the United States Treasury, Internal Revenue Service, Official Business. A chill traveled down her spine, a feeling that reminded her of the day she stood in front of the judge as he finalized her divorce. That was 18 months ago, yet it felt like yesterday. Trying not to panic, Suzanne nervously tucked the letter behind her bundle of junk mail as she walked back into the house. Her thoughts raced. What now? Am being audited? I never handled the tax returns! This is all Dan's fault, the bastard!
Suzanne sat down at the kitchen table, staring at the unopened letter, the official business letter. With a deep breath, she tore open the envelope, trying to stay calm. She read the words slowly, processing each one carefully. Underpayment penalties. Confusion set in; she had filed last year's tax return claiming all her income and even received a substantial refund. What had she missed?
Unbeknownst to Suzanne, alimony is income subject to state and federal income tax. If you are receiving alimony, you are expected to pay quarterly estimated tax payments on that income. Further, if you are separated, meet certain requirements, and are not yet divorced, you must still report alimony income on your state and federal tax returns when you file them. The American tax system requires that you pay your taxes as you earn income throughout the year. If you did not pay enough tax as Suzanne had, either through withholding or by making timely estimated tax payments, you will have underpaid your estimated tax and may have to pay a penalty (Underpayment Penalties).
According to the IRS, you must make Estimated Tax Payments in 2011 if:
• You expect to owe at least $1,000 in tax for 2011, after accounting for your withholding and refundable credits AND
• You expect your withholding and refundable credits to be less than the smaller of:
• 90% of the tax expected on your 2011 return OR
• 100% of the tax shown on your 2010 return
If you are employed, the tax withholding from your paycheck pays into the system for you. When you file your return, you reconcile the amount that has been withheld and the amount you owe. If the tax that you owe is less than the amount that has been withheld, then you get a tax refund. On the other hand, if the tax that you owe is greater than the amount that was withheld, then you owe money to the IRS to make up the difference. Since there is no withholding tax from alimony payments, you must manually submit your tax payments to the IRS yourself.
Here are Four Tips to Manage Your Estimated Federal Tax Payments:
1. Know The Deadlines
For calendar year-end tax payers, 2011 quarterly estimated tax payments are due on or before April 18, June 15, September 15, and January 16, 2012 (this 4th installment is not required if you file your tax return and pay any tax owed before February 1, 2012).
2. Plan Your Payments
Plan your cash flow carefully. Set aside cash on a monthly basis to pay for your estimated taxes. If you prepare your own tax returns, your computer program should estimate your tax payments for the following year. Otherwise, ask your accountant to project how much you might owe and monitor your income from all sources to make sure you are paying enough. To minimize your estimated tax payments, you can increase your withholding on income you receive from your job.
3. Pick a method of Payment:
There are four different methods of payment:
A check or money order using the Estimated Tax Payment voucher (You cannot send cash)
Electronic Federal Tax Payment System: payments will be directly withdrawn from either a checking or savings account. Visit www.eftps.gov for more information.
Electronic Funds Withdrawal: when you file your 2010 return, four payments can be scheduled to withdraw automatically from either a checking or savings account. Your payment schedule will be acknowledged once the IRS receives your return.
Credit or Debit Card: the IRS enlists the help of three different service providers. A convenience fee may be charged.
4. Report Your Payments on Your Tax Return:
To ensure that you get credit for payments made, remember to tell your accountant (or if preparing tax returns yourself, indicate on your return) that you have paid estimated tax payments.
If you are separated or divorced, it is important that you understand the tax implications of this major life change, from alimony to your filing status, so you can make the best financial decisions and prevent penalties so you do not receive that official letter from the IRS. For more information, see IRS Publication 505.
Gabrielle Clemens, JD, LLM, CDFA is a lawyer, a certified financial planner, and holds a master's in taxation. She is a Vice President of Investments at UBS Financial Services in Boston and works regularly with divorcing individuals and their attorneys, mediators and collaborative teams to provide clarity on the critical financial issues that arises before, during and after divorce. You can learn more about Gabrielle and her work supporting divorced individuals at UBS Financial or on LinkedIn.