The Counterproductive Estimated Tax Requirement

The requirement to pay estimated taxes on capital gains (along with its associated penalties for non-compliance) is counterproductive. It hurts both the taxpayer and the government and should be abolished.

Here's an illustration of what I mean. Let's say a man in the 35% tax bracket incurred a $1000 tax bill in the first quarter on an investment that earns him 20% a year. He could go ahead and send that money in to the IRS by the first quarter deadline to avoid a 5% penalty for the final three quarters of the year. This penalty would be $37.50 ($1000 x .05 x .75). Or he could go ahead and keep that money drawing the 20% for the last three quarters ($1000 x .20 x .75) for a total of $150. Of course, he would have to pay the $37.50 penalty when he files and the taxes on his additional $150 gains would be $52.50. That would still leave him with $60 ($150 - $37.50 - 52.50) that he wouldn't have had by just paying the estimated taxes. Even if there is a subsequent penalty on the $150 totaling $5.63 ($150 x .05 x .75), he would still be left with $54.37.

In the example above, many people would go ahead and send in the $1000 by the first quarter deadline in order to avoid the penalty. The rules encourage them to do this, but by doing so, they are cheating themselves and the government out of money. If the estimated tax requirement for capital gains were abolished, the man in my illustration would end up keeping an additional $97.50 ($150 - $52.50) and the government would get an additional $52 in tax revenue by letting him hold on to his money longer. In addition, the rules associated with estimated taxes are way too complicated and cause major inconveniences for taxpayers and IRS employees alike.

With all of that in mind, I so no reason why this requirement as it applies to capital gains should not be eliminated as soon as possible. Is the government so rich that can routinely turn away the extra funds? Does it just like to limit the earning ability of its citizens? Or does Congress just make a habit out of shooting itself in the foot? I think we all know the answer to that last question. Therefore, don't expect any changes to estimated tax rules any time soon.