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George Saenz, the Bankrate.com Tax Talk columnistPenalty for late estimated tax payment

Dear Tax Talk,
I exercised and sold my stock options in February of this year, but did not pay estimated taxes on the gain till September. I'd like to understand what fines and penalties I'll have to pay. We did not meet the 90-percent criteria for Q1, and I'm pretty sure that we also did not meet the 110 percent as well. Aside from the stock gain in the first quarter, income for the rest of calendar 2006 is not lumpy, and we would meet both the 90- and 110-percent criteria for the year, just not for Q1. We are able to do this with the interest and real estate taxes deduction from a vacation property bought in the second half of 2006.

-- Quyen

Dear Quyen,
Estimated tax is the method used to pay tax on income that is not subject to withholding. If you do not pay enough tax through the year by withholding or making estimated tax payments, you may be charged a penalty. Also, if you do not pay enough by the due date of each estimated payment, you may be charged a penalty, even if you have a refund when you file your tax return. To avoid the penalty, you can rely on two tests, as you pointed out.

Generally, you will not have to pay a penalty for 2006 if any of several situations apply.

Tests to avoid a tax penalty:

Estimated tax payments are due by the 15th day of April, June, September and January (of the next year). Withholding is considered paid one quarter before the due dates of the installments. Your income, deductions and tax are also assumed to occur evenly throughout the year.

If your income is uneven throughout the year (lumpy, as you say) you can use the annualized income installment method to avoid the penalty. This would help out a person who had a large gain (and hence tax) in a later installment period that did not make payments in earlier periods. Since you did not pay until September, and the installment for the tax on the stock options would have been due in April, and if not then, it should have been paid in June, this method will not reduce your estimated tax penalty.

Although it's termed "estimated tax penalty," it is really an interest charge. The interest rate is between 7 percent and 8 percent for 2006. If you failed to pay $10,000 in estimated tax for 2006, you could expect that your penalty would be between $350 and $400 for the year. The penalty will actually work out to a little more than half the interest rate applied to the underpayment. Since you were only short for a couple of quarters, expect to pay half of this half. See Publication 505 for more information on estimated taxes.

To ask a question on Tax Talk, go to the "Ask the Experts" page and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: Oct. 18, 2006
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