My investment accounts are not deducting taxes from my capital gains, causing me to owe large amounts when I file my tax return. How can I mitigate this situation?
-David
Because capital gains distributions are unpredictable and usually not known until the end of the year, they can be difficult to plan for properly. Being proactive and “prepaying” your tax bill can help you avoid having an unmanageable amount due in April.
Read on to learn more about how to manage your tax liability throughout the year. (Need help with a financial question? This tool can help you find potential advisors.)
Options for “prepaying” your tax bill
Instead of having to deal with a large tax bill in April, you have two options for paying taxes throughout the year: you can add or increase withholding taxes from another source of income, or you can make quarterly advance payments.
A third option would be to contact the mutual fund that generates the capital gains distributions directly and ask them about withholding. It’s possible the company will allow this, but it’s unlikely. As for your investment account, these institutions typically only offer withholding when you sell securities or take distributions from your retirement account.
Keep in mind that these strategies will reduce the amount you have to pay when you file your tax return, but they will not reduce your actual tax liability. (Need help with a financial question? This tool can help you find potential advisors.)
What are capital gains distributions?
Mutual funds and exchange-traded funds (ETFs) hold many underlying investments, such as stocks and bonds. During the course of the year, they may sell some of these investments, resulting in capital gains or losses within the fund. At the end of the year, the fund distributes a proportionate share of these sale proceeds to each investor—this is a capital gains distribution.
As an investor, you usually don’t know what to expect in terms of capital gains distributions until the end of the year. Funds publish information about expected distributions and expected payment dates on their websites, usually in November or December.
Unlike regular capital gains, which arise when you sell an investment for more than the purchase price, you have done nothing here. Your capital gains distribution is solely the result of transactions made by the fund itself. So even if you have not sold any units of your mutual fund, you have taxable income from these capital gains distributions.
This income is taxed like long-term capital gains, regardless of how long you actually own your fund shares. Long-term capital gains tax rates are based on your total taxable income and your tax status, so this income is taxed at either 0%, 15%, or 20%.
How can I deal with these taxes?
Because you won’t know how much you’ll receive in capital gains distributions until late in the year, it can be difficult to accurately estimate how much tax you’ll owe — but you can get close enough to at least avoid IRS underpayment penalties. The IRS has safe harbor policies: As long as you pay at least 90% of your current tax liability, 100% of the previous year’s tax liability, or owe less than $1,000, you can avoid underpayment penalties even if you still owe at the end.
Both methods require you to have a good idea of what your annual income will be at the beginning of the year, which isn’t always practical. You can start with your best estimate and make adjustments as needed throughout the year. (Looking for help with a financial question? This tool can help you find potential advisors.)
Start or increase withholding tax on other income
If you have other sources of income, such as a regular W-2 job or a government pension, you can request that enough taxes be withheld to cover that extra income. You can even request withholding from Social Security payments.
If you have an online account for your other source of income, you can probably request or change withholding right there. You fill out a Form W-4 (or equivalent) and enter the amount you want to withhold on the “Additional Withholding” line. For government payments like Social Security, you use Form W-4V and select the percentage you want to withhold. You can also stop this withholding at any time by updating your selections.
Make quarterly advance payments on your taxes
Once you know roughly how much tax you owe, you can divide that amount by four and make equal prepayments each quarter. You can either fill out IRS Form 1040-ES and mail it to your designated IRS mail center along with a check, or make your payment online at the IRS website. If you pay online, be sure to select “prepayment” as the reason and the correct current tax year.
Pro tip: If you are making advance payments on a jointly filed tax return, be sure to use the Social Security number of the one of you who is listed first on the return (as the “taxpayer” and not the “spouse”). The IRS system sometimes applies payments incorrectly or incorrectly when the other Social Security number is used.
Advance payments on the tax due date amount to:
Advance payments vs. withholding taxes
Note that there are more penalties associated with prepayments than withholding. Plus, withholding is much easier to manage because you can set it and then forget it, rather than having to proactively remember to make a payment each quarter. (Need help with a financial question? This tool can help you find potential advisors.)
Next Steps
There are two ways to avoid a large tax bill in April. You can withhold additional taxes on another source of income, or you can make quarterly advance payments. Either way, you spread your taxes out over the entire year rather than receiving a lump sum when you file your tax return.
Find a financial advisor
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If you have questions about your investment and tax situation, a financial advisor can help. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. You can interview the advisors assigned to you for free to help you decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, get started now.
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Understanding your tax bill can help you make plans for your money. Whether you’re saving for retirement, paying off student or credit card debt, or investing your money in other ways, SmartAsset’s tax refund calculator can help you figure out how much you’ll get back from the government so you can plan ahead.
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Have an emergency fund ready in case unexpected expenses arise. An emergency fund should be liquid – in an account that is not exposed to the risk of large fluctuations like the stock market. The downside is that the value of liquid cash can be eroded by inflation. However, a high-yield account allows you to earn compound interest. Compare savings accounts from these banks.
Michele Cagan, CPAis a financial planning columnist for SmartAsset and answers readers’ questions about personal finance and tax issues. Have a question you’d like answered? Email [email protected] and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAsset AMP platform, is not an employee of SmartAsset, and has received compensation for this article.
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