Some Extra Withholding Now Can Ease the Pain in April

Though the market's looked bleak recently, some investors have banked big gains this year. If you're one of them, it's time to start thinking about how to pay the taxes on those gains.

If you're a salaried employee, consider jacking up your payroll withholdings for the rest of the year to cover the tax rather than making a lump-sum estimated payment. And if you're part of an S corporation, like many traders, a recent Internal Revenue Service release points out that you can issue yourself a year-end paycheck and withhold the entire amount to cover your annual tax bill without incurring penalties.

Both of these techniques are exceptions to the general IRS rule that requires you to pay your taxes in equal portions throughout the year. That's why you have taxes withheld from your paycheck each pay period rather than writing a big check at tax time. (Though if you calculate wrongly, you may end up doing both.) In addition, people who make estimated tax payments are required to pay them in equal installments throughout the year. If you make a big payment in the third quarter, for example, but didn't pay a thing in the first two, you may owe interest and penalties for not paying regularly throughout the year.

The great thing about increasing your payroll withholdings at year-end is that the IRS assumes the payments were made evenly throughout the year, says Martin Nissenbaum, director of income tax planning at Ernst & Young. So if you've been underwithholding all year and you decide to do something about it in the fourth quarter, you can give up one whole paycheck or more if you need to without a peep from the IRS. And if you have a big capital gain, a surprise inheritance or an IRA-to-Roth IRA conversion, increasing your late-year withholding may be the way to go.

So, how do you know if you should increase your withholdings?

The rule says that if your 1999 adjusted gross income was less than $150,000, you must pay at least 90% of your 2000 taxes or 100% of the tax you paid in 1999 through withholdings, estimated tax payments and/or credits.

The withholding rate is higher if your 1999 adjusted gross income was more than $150,000. Then, 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 estimate for 2000 is off, you'll owe underpayment penalties.

Check Your Paycheck
If your 1999 adjusted gross income is	Your 2000 withholdings must exceed
Less than $150,000	100% of your 1999 taxes or 90% of your 2000 taxes.
More than $150,000	108.6% of your 1999 taxes or 90% of your 2000 taxes.
Source: IRS

If it looks like you won't meet either of these tests with your current withholdings, it's time to visit your payroll department. Many companies will not let you adjust your withholdings after Oct. 1 because it's too much administrative work, says Nancy Anderson, education coordinator in the corporate tax area of H&R Block (HRB).

But if you're the sole member of an S corporation, you have much more control over how much you are paid and what will be withheld.

An S corporation can make distributions of profits to its shareholders and pay them salaries. Profit distributions are not subject to FICA, a.k.a. payroll tax (6.2% withheld for Social Security and 1.45% for Medicare). But salaries are. So lots of people use S corporation distributions as a way to avoid FICA tax, says Nissenbaum. (Check out a recent Vern Hayden column for more on setting up an S corporation.)

It's no surprise that the IRS has caught on. If you take too many distributions without paying yourself a salary, you may owe back FICA taxes on those distributions, says Anderson.

But if you're the only member of the S corporation, you're not obligated to take a salary or distributions. If your business is struggling through its early years, you may not be able to take either. So it's justifiable for you to realize at year-end that you have extra money. The recent IRS alert confirms that you can then pay yourself a bonus in December and have the whole thing withheld to cover your tax bill.

So if you've blown off making estimated payments or if you did some serious profit-taking, you can still avoid a tax slaughter in April.

And while you may take home less money in December as a result of your increased withholdings, be happy knowing you've kept your hard-earned money away from Uncle Sam for most of the year.

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