How Carryovers, Capital Gains and Roth IRAs Affect Estimated Taxes

Your Sept. 8 article titled "Do I Have to Pay Estimated Taxes on Short-Term Investments?" was very interesting. I have a few questions. When calculating estimated tax payments for the current year, should one also take into account past years' investment loss carryovers? Those carryovers might partially offset, or even cancel out, any current year-to-date gains. Also for estimated payments, do I need to calculate short-term and long-term gains separately?

Peter Lochowicz

Peter,

Great questions, Peter, considering your third-quarter estimated tax payment is due by midnight Friday, Sept. 15.

The estimated tax payment test you choose to satisfy will determine whether you need to worry about your losses carried forward from previous years or any current-year gains and losses. (As a reminder, after you've netted your capital losses against your gains, the next $3,000 in losses beyond that can be subtracted from ordinary income, reducing your taxes; the remaining losses are carried forward to offset any future gains.)

There are two tests to determine if you need to make estimated tax payments, but they differ slightly depending on your 1999 adjusted gross income.

If your 1999 adjusted gross income was less than $150,000, then you must pay either 90% of your 2000 taxes or 100% of your 1999 tax bill through payroll withholdings, credits and/or estimated payments.

If your 1999 adjusted gross income was more than $150,000, you must pay either 108.6% of your 1999 tax or 90% of the current year's tax.

Generally, it's safer to use last year's tax bill as your litmus test, because if your estimation for 2000 is off, you'll owe underpayment penalties. And by paying in last year's tax bill you won't have to worry about current year's gains, losses or carryforwards.

But if your income has changed from the prior year and you'd prefer to go with the 90% rule, then you must do a mini-projection of your current year's tax situation, says Bill Fleming, director of personal financial services for PricewaterhouseCoopers in Hartford, Conn. You'll need to put together a pseudo 2000 tax return, so use Turbo Tax or some other tax preparation software. Then prepare your return as if it were April 15, 2001. Include all your wages and income, including upcoming bonuses, salary increases and short-term and long-term gains and losses. In addition if you have any capital losses that can be carried forward from previous years, include those in your calculation as well.

Can the Roth Bring on Estimated Tax Payments?

I read your recent column on estimated taxes with interest. I am entering my second year of business school, so 2000 will likely be my last year of eligibility for a Roth conversion. I would like to convert a $27,000 traditional IRA into a Roth. This should increase my tax bill by about $8,000. If I make a one-time estimated tax payment during the fourth quarter, will I get penalized for not making estimated payments in the first three quarters? Due to money earned during the summer, the combined income (and taxes withheld) of my wife and myself will be just about the same in 2000 as it was in 1999. This seems to be a no-win situation for me if a penalty will apply.

-- David Lichtman

David,

So I guess you're assuming that business grads are making more than $100,000 these days, since you can't convert your traditional IRA to a Roth if your adjusted gross income exceeds $100,000, as a single or married person. If Wall Street keeps paying top dollar, you very well might be disqualified from a conversion in future years. Kudos to you.

Even if you haven't been making estimates in the past, receiving a large chunk of money may force you to do so in the future. That extra money can come from a big gain thanks to the sale of stock, a bonus or even a Roth conversion. So you need to re-evaluate your estimated tax situation.

While you might owe a payment, you don't necessarily owe a penalty as long as you annualize your income, says Fleming. As we discussed last week, "annualizing" your income allows you to show the Internal Revenue Service that you did get this money equally throughout the year.

Taxpayers who annualize must file Form 2210 -- Underpayment of Estimated Tax by Individuals, Estates and Trusts, which walks you through the calculation. But the form also shows the IRS that your income hasn't been a steady stream throughout the year because it details the quarterly flow of your income. It will also show that as a result of withholdings, you paid in enough in the earlier quarters.

So in your instance, let's assume you convert to the Roth in the third quarter. Your Form 2210 will show that extra income in that specific quarter. If the amount is large enough, you may owe a third-quarter estimated tax payment, due Friday, Sept. 15.

Big note to anyone who annualizes: Since the process requires tallying up the current year's income, you only need to pay in 90% of the tax due on that income, according to the rules in Peter's question above. If you're making a third-quarter payment then, you need to pay in 75% of 90%, says Martin Nissenbaum, director of income tax planning at Ernst & Young. The remainder is due on Jan. 15, 2001. Form 2210 helps you calculate these percentages.

If the extra amount of tax owed as a result of the conversion is not that large, you may be able to cover the higher tax bill by bumping your wife's withholdings. Since she is employed, she may ask her employer to withhold extra taxes from her paycheck each week to cover the excess taxes owed.

Pull Out the Plastic

Don't have the cash to make your estimated payment? Remember, you can dial 888-2PAY-TAX and charge your estimated tax payment on your American Express, Discover or MasterCard. If you charge it over the phone, you won't have to file Form 1040-ES -- Estimated Tax for Individuals. Just keep in mind that Official Payments (OPAY Quote) of San Ramon, Calif., the intermediary between you and the IRS, charges a "convenience" fee for using a credit card. The fee averages 3% to 4% of your payment. Check out the Official Payments Web site for the complete payment scale. And read this previous Tax Forum for more details.

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