My investment accounts don’t withhold taxes from my capital gains, which is causing me to owe large amounts when I file my returns. How can I mitigate this situation?
-David
As capital gains distributions are unpredictable and usually unknown until the end of the year, it can be difficult to properly plan for them. Taking proactive steps to anticipate and “prepay” your tax bill can help you avoid an unmanageable balance due in April.
Read on for more information on how to manage your tax liability throughout the year. (Looking for help with a financial question? This tool can help match you with potential advisors.)
Options to ‘Prepay’ Your Tax Bill
You have two main options for paying taxes throughout the year rather than dealing with a huge tax bill in April: adding or increasing withholding taxes from another income source, or making quarterly estimated tax payments.
A third possible option would be to contact the mutual fund generating the capital gains distributions directly and ask it about withholding. It’s possible that the company would facilitate that but not likely. As for your investment account, those institutions typically only offer withholding when you sell securities or take retirement account distributions.
Be aware that using these strategies will reduce the balance you have to pay when you file your taxes. But they won’t reduce your actual tax bill. (Looking for help with a financial question? This tool can help match you with potential advisors.)
What Are Capital Gains Distributions?
Mutual funds and exchange-traded funds (ETFs) hold lots of underlying investments like stocks and bonds. During the year, they may sell some of those investments, resulting in capital gains or losses inside the fund. At the end of the year, the fund distributes a proportional share of those sale proceeds to each investor – that’s a capital gains distribution.
As an investor, you generally won’t know what to expect in terms of capital gain distribution income until late in the year. Funds typically post information about estimated distributions and expected payout dates on their websites in November or December.
Unlike regular capital gains, which come into play when you sell an investment for more than its purchase price, you haven’t taken any action here. Your capital gains distribution is purely the result of trades that the fund itself made. So even though you haven’t sold any shares of your mutual fund, you’ll have taxable income from those capital gains distributions.
This income will be taxed like long-term capital gains, no matter how long you’ve actually owned your fund shares. Long-term capital gains tax rates are based on your overall taxable income and filing status, so this income will be taxed at either 0%, 15% or 20%.
How Can I Deal With These Taxes?
Since you won’t know until late in the year how much you might receive in capital gains distributions, it can be tough to estimate the tax bill exactly – but you can get close enough to at least avoid IRS underpayment penalties. The IRS has safe harbor guidelines: As long as you pay at least 90% of your current tax bill or 100% of the prior year’s tax bill, or owe less than $1,000, you can avoid being charged underpayment penalties even if you end up owing.
Both methods ask you to have a good sense of what your annual income will be early in the year, which isn’t always practical. You can start with your best estimate and make adjustments during the year if needed. (Looking for help with a financial question? This tool can help match you with potential advisors.)
Begin or Increase Withholding on Other Income
If you have other income sources, such as a regular W-2 job or federal retirement income, you can request that they enough withhold taxes to cover this additional income. You can even request withholding on Social Security payments.
If you have an online account for your other income source, you can probably request or change withholding taxes right there. You’ll complete a Form W-4 (or the equivalent) and enter the amount you want withheld on the line that says “extra withholding.” For government payments like Social Security, you’ll use Form W-4V and choose the percent you want withheld. You can also stop this withholding at any time by updating your choices.
Make Quarterly Estimated Tax Payments
Once you know approximately how much tax you’ll owe, you can divide that by four and make equal estimated tax payments every quarter. You can either complete IRS Form 1040-ES and mail that with a check to your designated IRS mailing center or make your payment online at the IRS website. If you pay online, make sure you choose “Estimated Tax” for the reason and the correct current tax year.
Pro tip: When making estimated tax payments for a jointly filed tax return, make sure to use the Social Security number of whichever of you appears first on the tax return (as “taxpayer” rather than as “spouse”). The IRS system sometimes misapplies or does not apply payments properly if the other SSN is used.
Estimated tax due date payments are:
- April 15
- June 15
- Sept. 15
- Jan. 15
(If the 15th falls on a weekend or holiday, the payments are due the next business day.)
Estimated Tax Payments vs. Withholding Taxes
Be aware that there are more potential penalties associated with estimated tax payments than withholding taxes. It’s also a lot easier to manage withholding as you can set it and forget it, as opposed to remembering to proactively make a payment every quarter. (Looking for help with a financial question? This tool can help match you with potential advisors.)
Next Steps
There are two ways to avoid paying a large tax bill in April. You can withhold extra taxes on another source of income or make quarterly estimated tax payments. Either way, you’ll be spreading out your taxes over the whole year instead of coming up with a lump sum when you file your tax return.
Find a Financial Advisor
- If you have questions specific to your investing and taxation situation, a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Understanding your tax bill can help you make plans for your money. Whether you plan on saving for retirement, paying off college or credit card debt, or investing your money differently, SmartAsset’s tax return calculator can help you figure out how much you will get back from the government so you can plan ahead.
Michele Cagan, CPA, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAdvisor Match platform, and she has been compensated for this article.
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