An Alternative to Quarterly Estimated Tax Payments?

Year-End Tax Timing: W-2 Withholding vs. Quarterly Estimated Payments

For high-income earners, business owners, and investors, timing tax payments strategically can have significant cash flow and present value benefits. A commonly overlooked strategy involves paying taxes via W-2 wage withholding in December, rather than making quarterly estimated tax payments throughout the year. Understanding this difference—and the interplay with the Pass-Through Entity (PTE) Tax Deduction—can help maximize your tax efficiency.

Quarterly Estimated Payments: The Standard Approach

The IRS and state tax agencies generally require taxpayers to make quarterly estimated payments if they expect to owe at least $1,000 in taxes after subtracting withholdings and credits. These payments are due in April, June, September, and January of the following year.

While this system ensures taxes are paid incrementally, it ties up cash flow throughout the year, which could otherwise be used for investments, debt reduction, or running your business.

W-2 Withholding in December

For taxpayers with flexibility in structuring compensation, paying taxes via W-2 withholding in December offers a powerful alternative. Here’s why:

1. Deemed Timely Withholding:

   • Unlike estimated payments, W-2 withholdings are considered paid evenly throughout the year, no matter when they are actually withheld. Even if you withhold a lump sum in December, it satisfies the requirement to avoid underpayment penalties.

2. Cash Flow Benefits:

   • By retaining your cash until the end of the year, you can use those funds to generate returns, such as reinvesting in your business, making portfolio investments, or covering other expenses. This delayed outflow improves liquidity and financial flexibility.

3. Present Value Savings:

   • Delaying payments until December reduces the time value of money loss associated with making payments earlier in the year. By keeping funds longer, you effectively reduce the cost of the taxes in present value terms.

   • Savings can be range from the hundreds to thousands, depending on taxes due and your return on capital.

   
   

Pass-Through Entity (PTE) Tax Deduction

For owners of pass-through entities (such as S-Corps, partnerships, or LLCs), the PTE tax deduction can provide significant benefits when planning tax payments. Here's how it works and its interplay with W-2 withholding and estimated payments:

1. Deduction Overview:

   • Many states now allow pass-through entities to pay state income taxes at the entity level, rather than requiring individual owners to pay through personal filings. This enables the tax payments to be treated as a business expense, effectively circumventing the $10,000 SALT (State and Local Tax) deduction cap for individual taxpayers.

2. W-2 Considerations:

   • Our Savviest clients often combine PTE tax planning with W-2 withholding strategies. For example, owners can reduce their estimated state payments by maximizing PTE tax payments through their entity while using W-2 withholding to cover federal liabilities at year-end.

3. Estimated Payment Reduction:

   • The PTE election may eliminate the need for quarterly state tax payments altogether.

   
   

Potential Risks and Limitations

While the benefits of year-end W-2 withholding and PTE tax deductions are compelling, there are a few considerations to keep in mind:

1. Underpayment Penalties:

   • W-2 withholding avoids penalties when implemented correctly, but falling short of the payment thresholds will still trigger penalties for estimated taxes. Note: There are safeharbors that your tax advisor can help you with to avoid this.

2. Liquidity Requirements:

   • Withholding a large sum in December requires sufficient liquidity at year-end. This strategy may not be suitable if cash flow is tight.

3. State-Specific Rules:

   • PTE tax deductions vary by state, with some requiring elections or specific filing procedures. Work closely with a tax advisor to ensure compliance.