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Does it make sense to prepay your taxes?

December 09, 2008

One of the oldest tax planning tricks in the book is paying in December state and local taxes that aren't due until next year. That way you get get the benefit of the deduction one year sooner. If it works, you could get a tax benefit on your April 2009 filing, rather than your April 2010 filing.

Does the math work? Not always. I ran a little computation for a hypothetical taxpayer who will face the same marginal tax rate this year and next without owing alternative minimum tax, and without estimated tax underpayment penalties or other side issues taken into account. I take into account the value of the prepayment on the return next April to the foregone interest would have earned on the state and local taxes if you had waited to pay them until the due date, using a 4% discount rate. The results are below; the circumstances where prepaying works are in green, and the due date for the prepaid taxes are on the left side.


In short, unless you are in the top bracket, prepaying your Iowa state income taxes due April 30 doesn't make sense. 28% and 33% bracket taxpayers might benefit from prepaying property taxes due March 1.

Of course, other factors come into play. If you are in AMT both years, you get no benefit of prepaying taxes, because the deduction is worthless. If you are in AMT in one year and not the other, it only makes sense to pay the state and local taxes in the non-amt year. In any case, you have to have a decent two-year tax projection to make the call. If the dollars are big, get your tax advisor involved.

UPDATE: Robert Flach makes a good comment: for taxpayers meeting our simplifying assumptions, it always makes sense to prepay a fourth quarter state estimate otherwise due in January, if you itemize in the first place.

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What the chart does show is that it is "more better" to make the 4th quarterly 2008 state estimated tax payment - normally due by mid-January 2009 - in December 2008. At the January 31 level every tax bracket is in "the green".

This is what I advise my clients who make quarterly estimated tax payments.


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