Avoid The Underpayment Penalty

As a financial advisor, I look at a lot of tax returns. I’m usually looking for key tax information that guides long-term tax planning. But, something that I’ve noticed is an uptick in people owing an underpayment penalty to the IRS.

I’m not sure what is causing the increase – a byproduct of the recent tax changes? – but if it’s impacting you there are a few ways that you can avoid the penalty and save yourself a few hundred dollars.

What is it, how does it happen, and am I paying?

You owe an underpayment penalty if you didn’t pay enough taxes throughout the year. This can happen even if you are a salaried employee.

Most of the time, employees have taxes withheld from their paychecks and the employer sends them to the IRS. But if you claim the wrong number of allowances on your W-4 you could end up underpaying.

Also, if you a regular employee and have income from other sources you could also be underpaying.

It’s even easier to underpay if you’re self-employed, a freelance worker, or retired. You don’t have taxes withheld as you earn income. You’re required to make estimated quarterly payments based on what you earn, which can be variable. This makes it easy to miscalculate the taxes owed or even skip a payment on accident.

You’ll be able to tell if you’re paying an underpayment penalty by looking at line 24 on page 2 of Form 1040. If there is a number there, it’s likey from an underpayment of taxes.

How to avoid it

Generally, most people will avoid the penalty if they:

  • owe less than $1,000 in tax after subtracting their withholdings and credits
  • had no tax liability the previous year
  • paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller
  • for high-earners, it’s 90% of the current year or 110% of the prior year, whichever is smaller

The penalty may be waived if either:

  • you experienced an event, like a natural disaster, that caused the underpayment or,
  • you are retired (after reaching age 62) or became disabled during and the underpayment was due to reasonable cause, not willful neglect

You’ll have to submit the request for the waiver in writing when you submit your tax return.

If none of the above apply to you, you can’t undo what’s done. You’re stuck with an underpayment penalty but you can take steps to avoid one going forward.

If you’re a regular worker, start by increasing your withholdings on your W-4 so that more tax is taken out of each paycheck. Here is a link to the IRS’s tax withholding calculator to help you determine the amount, https://www.irs.gov/individuals/tax-withholding-estimator

If you’re a worker with income from outside sources, also consider increasing your W-4 withholdings, or make estimated tax payments to cover your taxes. I think that having the amount withheld from your paycheck is much easier than writing quarterly checks to the IRS.

If you’re self-employed, a freelancer, or retired be sure to make your estimated payments for the current tax year by the deadlines. I recommend setting up an automatic monthly transfer from your checking (or business checking) into a separate account that’s earmarked for your estimated payments. That can help you avoid a cash squeeze when it’s time to send the checks in.

If you’re retired and have IRAs, you can more taxes withheld from each distribution from you IRA. This works especially well if you are taking required minimum distributions (RMDs) but don’t need the income.

When Should I Update My Estate Plan?

There are many different documents that can make up an estate plan. Some of these documents include last wills and testaments, a living will, a revocable living trust, power of attorney, and even a digital estate plan.

Having an estate plan can give you peace of mind that you’ve taken the necessary steps to protect your loved ones in the event that you pass away, or enable them if you aren’t able to take make decisions on your own anymore.

But the estate planning process isn’t a one-time thing. Life brings changes and your estate planning documents will need to change with it. If your plan isn’t revisited and revised, then it may not accomplish the goals that you want it to.

So when is it appropriate to update your estate plan?

When You Should Update Your Estate Plan

It may seem pretty obvious, but the best time to update your estate plan is when you have any major changes in your life.

Some common life events that can spur revisiting the documents include:

Marriage And Divorce

Whether you’ve just tied the knot or parted ways with your spouse, you should review your estate plan.

Make sure your new spouse is included in your estate plan or your ex-spouse is removed from it. Do this as soon as possible to ensure your finances are in line with your wishes.

If you pass away before your estate plan documents are updated, you risk your assets being distributed in a way that you wouldn’t want. For example, if you get a divorce and pass away before your will is updated, your ex-spouse may be entitled to some of your assets.

Children

One of the most common reasons for updating an estate plan is changes that occur within a family such as having a new baby, adding stepchildren, or your children simply getting older.

If you’ve remarried and had children from your first and second marriage, you will want to address this in your estate plan. This also goes for any stepchildren that you would like to include in the distribution of your estate since they’re usually not included by default.

If your children have reached the age of 18 or the age of majority in your state, they no longer need to have a guardian and this language can be removed from the documents. You may also wish to add your adult children as your personal representative or durable/health care power of attorney at that time.

Named Individual (Fiduciary) Changes

When you review your estate plan, you should check the people you’ve listed that are going to be responsible for making decisions on your behalf. These include:

The individual(s) named above as your Personal Representative (and successors) will handle the settlement of your estate after you pass away. The term “executor” is an older word for the same role.

The individual(s) named above as your Trustee (and successors) will handle your trust assets while you are disabled and after you pass away. Assets that are not inside your trust will be handled by your Power of Attorney (next section) while you are still living.

The individual(s) named above as your Attorney-In-Fact and Health Care Representative (and successors) will make financial and health care decisions for you while you are still alive but unable to make such decisions on your own. 

Federal, State, and Tax Law Changes

The tax law is constantly changing so this is something you will need to take into account with estate planning. Take for example the SECURE Act, which went into effect on January 1, 2020. Many individuals who own IRAs and 401(k)s will need to make changes in their estate plans to address the impact of that legislation on inherited accounts.

Also, if you move from one state to another make sure your documents follow all local and state laws. You should review your plan documents with an estate planning attorney in your new state to ensure compliance with all the laws of that state.

review Your Estate Plan often

Understandably, trying to remember to review your estate plan when things change isn’t always easy. The truth is, most people don’t keep their estate plan up-to-date all the time.

For this reason, it is good practice to review your estate plan every 3 to 5 years or set aside a specific time each year to do a quick check-in, such as the new year or during tax time.

How Should I Invest My 401(k)?

A byproduct of being a financial advisor is the random financial advice texts from friends and family. One of the most common by far is, “What should I pick in my 401k?”.

While I try to be as helpful as possible, I can usually only answer with, “It depends…”.

Without knowing the fund offerings of the 401k plan, your investments outside of the 401k, your goals, and your risk tolerance, there is practically no way to say which investment options to choose.

Having said that, there are general tips that anyone can apply when making decisions related to a 401k.

Before we get to that though, I think it’s important to understand the basics of investing.

Back to the Basics

There are three basic choices when it comes to investing:

  • Cash or investments that can be turned into cash quickly. Sometimes also called capital preservation.
  • Bonds, which is essentially you loaning money to a government or corporation in return for a fixed payment back.
  • Stocks, which is a share of ownership in a corporation.

Historically, capital preservation and bonds are less risky than stocks but have a lower potential for return.

You’ll probably notice there aren’t any individual bonds or stocks listed as investment options in your fund line up. That’s because it’s hard for the average investor to purchase enough individual stocks and bonds to create a portfolio that is varied enough. So instead, you have a variety of mutual funds or exchange-traded funds (ETFs) to choose from.

Mutual Funds and ETFs. What are those?

Both mutual funds and ETFs are pools of money that are managed by a professional money manager and have a stated objective, such as investing in only Large U.S. tech companies or tracking an index.

The biggest advantage of mutual funds and ETFs is the instant diversification it can give you. That’s because the money manager is able to pool your money with thousands of other investors and purchase a mix of individual stocks and bonds that you wouldn’t have been able to otherwise.

Diversifying helps reduce your overall risk. Think about what your parents used to tell you, “don’t put all of your eggs in one basket!”. With mutual funds and ETFs, you are spreading your money across enough investments to reduce the risk of being wiped out by a single bad bet.

Just because you diversify doesn’t mean you don’t run the risk of losing money. The markets fluctuate up and down, and sometimes, they come down a lot. But that’s okay because contributions will be going into the account on a regular basis.

Having money going into your account every month enables you to build significant wealth. That’s because if the price of the investment drops, you are buying it at a discount. We all like buying things at discounts!

so… What Should I Choose?

Luckily, a majority of the hard work has already been done for you. Through a rigorous screening process, an investment fiduciary has pre-selected which mutual funds and ETFs are available to choose from. This is commonly known as the fund lineup.

TIP 1: Everyone is different when it comes to how they want to invest their retirement plan account, and before you make any decisions, I recommend filling out a risk profile questionnaire. This will give you an idea of what type of asset allocation fits your proximity to retirement and your willingness/ability to take risks.

Asset Allocation Matters

Asset allocation simply explains the mix of stocks, bonds, and cash in which you decide to invest. Broadly speaking, the younger you are the larger the share of stocks you should have in your 401k. As you approach retirement there should be a more balanced mix between stocks and bonds as you switch from solely focusing on growing your money to also caring about preserving it.

It’s common to see funds within your 401k plan that basically use autopilot to shift your asset allocation from stocks to bonds as you get older. These are known as Target Date Funds (lifecycle, target retirement) and you’ll usually see a naming convention like Target Date 2045. The year being your goal retirement date.

TIP 2: A mistake I often see is someone choosing a target-date fund but then also having other mutual funds selected that are being invested in the same manner. This means they are doubling their exposure to that asset class and paying twice the fees for no benefit at all! Stick with either a mix of stock and bond mutual funds that meet your asset allocation goals or go with a corresponding target-date fund, but not both.

keep fees in mind

TIP 3: No matter what investment options you go with, always keep fees in mind. They are usually referred to as the “expense ratio”.

The fees on the various funds can vary significantly too. According to the Investment Company Institute, in 2019, the average expense ratio of actively managed equity mutual funds was 0.74% compared to passive stock mutual fund expense ratios of 0.07%. This means that the bill on the $100,000 invested in your 401k could be $740 or $7 a year. Assuming 5% growth per year on that $100,000 for the next 20 years – the 0.74% fund would have a cost of $33,500.

There are very few factors under your control when it comes to future investment results, but one that you do control are the fees you pay.

Tax Efficient LLC

I have a friend that is starting a business and they asked for my advice on the most tax-efficient way to set it up (i.e. how to pay the least amount of taxes possible).

After some discussion about what the business is and how much they expect to make, we landed on establishing a Limited Liability Company (LLC) and to elect filing taxes as an S-corporation. In short, here’s why.

Key points:

  1. S Corporations have some tax planning unavailable to your run-of-the-mill LLC. The FICA tax for Social Security and Medicare (also known as self-employment taxes) only applies to wages paid to owner-employees. The remainder of the net earnings passes through as dividend income.
  2. S-Corps avoid double taxation by reporting the gains and losses on the shareholders’ individual tax returns.
  3. For tax years 2018-2025, a deduction equal to 20% of the share of an S-corporation’s profit can be claimed, subject to limitations.

Self-employment tax savings

Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law. 

LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners. As your income from your LLC increases, so does the self-employment tax. You earn more, you pay more tax.

An S-Corp lets you split your profits into “shareholder wages” (subject to 15.3% Social Security, Medicare, and self-employment taxes) and “distributive share” (NOT subject to 15.3% Social Security, Medicare, and self-employment taxes).

An owner of an LLC with pass-through taxation pays 15.3% on the entire profits. Active owners in an S-Corp must pay themselves a reasonable salary (more on this down below), but realize a 15.3% savings on the rest of their retained profits.

avoid double taxation

Usually, corporations are taxed as its own entity. The corporation files IRS Form 1120 each year to report its income, deductions, and credits, and profits are typically taxed at corporate income tax rates.

That’s pretty cut and dry, but where small business owners can run into trouble is through something called double taxation. That’s because when the corporation distributes dividends to the stockholders (the business owner), these dividends are taxed on their personal tax returns.

If you’re a small business owner and expect to put some of the profit into your own wallet, the money could end up being taxed twice: first, the corporate profits are taxed at the corporate level and then the distributions are taxed on an individual level.

When filing as an S Corporation, the company itself no longer pays taxes on the profits. Instead, any profit or loss is passed to the owner and they report it on their personal tax return.

QBI deduction

In 2017, the Tax Cuts and Jobs Act established IRS Code Section 199A, which provides a 20 percent deduction for eligible pass-through entities with qualifying business income (“QBI”). This new provision has the ability to reduce the maximum individual tax rate of 37% on pass-through income to approximately 29.6%, making it more equitable to the C corporation tax rate of 21%.

The QBI offers a way to lower the effective tax rate on the profits of owners of pass-through entities. These include sole proprietorships (including independent contractors), partnerships, limited liability companies, and S corporations.

Salary amount

As the owner of an S Corp, you take a salary and only this portion is subject to FICA and Medicare taxes.  Any remaining profit that is distributed is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes. 

Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves the least amount possible.  The IRS is aware of this incentive and requires shareholders to pay themselves a reasonable salary. 

What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure. You may hear the general rule of that salary can be two-thirds of net income. However, take this with a grain of salt. The salary number is very subjective relative to industry standards and should be supportable.

It’s advisable to work with a Certified Public Accountant to determine how much is a reasonable salary for the field you are in.

How To Avoid Being A Victim of Scams and Other Online Threats

Have you ever received an email like the one below?

This is a real email that I received.

These “foreign money exchange” schemes typically start with an email from someone overseas who claims to be royalty or businessperson. The fraudsters lure you in by offering a share of a huge investment opportunity or a fortune they can’t get out of the country without your help.

Then they ask you either for your bank account number so they can transfer the money to you for safekeeping, or for a small advance payment to help cover the expense of transferring the money.

You may laugh at the insanity of falling for such a fraud but the FBI reports that potentially millions of dollars are lost each year to these scams.

How To Protect Yourself

There a few ways online criminals access our money, by relying on our emotions and ignorance or by stealing it directly using technology.

The first line of defense against scams is to question everything. Also, be confident to say no.

If you get an email from Dr. Gilberto Churchill offering a large sum of money, it’s probably not real. The old adage “if it sounds too good to be true it probably is” comes to mind.

Or if you receive a call from the Social Security Administration saying that your Social Security number is going to be suspended unless you take immediate action. Would the Social Security Administration make a call like that? Not likely. If you think there might be some legitimacy, refuse to give any personal information to them, hang up and call a number that you know.

As for the technology side of things, the first thing we can do is regularly update our operating system and applications. The companies who create the software recognize holes in their security and periodically release updates to combat it.

Avoid clicking on pop-up windows or attachments unless they are from a trusted source and you are expecting them. You’ll also want to make sure your security software (antivirus, spyware, firewall) is running and up to date in case you accidentally click on a malicious link.

Don’t use public Wi-Fi unless you have a VPN (virtual private network). It’s a lot easier for criminals to access your information if you use a non-secure network.

I recommend using a secure password system to manage your various online accounts, email, and other online services. A summary of these services can be accessed at this link, Password Managers. If you are not comfortable with online technology tools, ensure your various passwords are complex, secured, and accessible to family members.

Experts also recommend backing up your files to an external hard drive every few weeks, especially since malware can be incredibly difficult to remove. In the case of ransomware, even if you do successfully remove it, your files may still remain inaccessible.

If You Become A Target

If you realize that you fell for a scam or fear that your computer is infected with malware, you’ll want to act as quickly as possible to prevent any further damage.

Do NOT pay the scammer any more money and contact your bank to see if they can reverse what has been paid. You’ll also want to notify your state consumer protection office and report it to your local police too.

If your computer is being held ransom with malware, do not pay the hacker. These are not legitimate business people. Once they have your money (and the ransom is usually pretty expensive), they have no incentive to follow through on any promises to unlock your machine or files. This is where always backing up your files to an external hard drive will come in handy.

Although a scam can be financially devastating if you become victim to one, you can drastically reduce your vulnerability by educating yourself, practicing good online habits, and keeping your devices up to date.