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Should you prepay your taxes due next year?

December 15, 2009

One of the most common tax planning tricks is to pay in December taxes that are otherwise due in January and April. For income taxes, this is usually done by sending the taxes in as additional estimated payments. For property taxes, you just send the check in early.

Does this make sense? Maybe, if you meet some conditions:

- If you are prepaying state and local taxes, you need to itemize. Many folks, especially those over 65, have a big enough standard deduction that they don't need to itemize.

- If you are subject to alternative minimum tax in 2009, a deduction for state and local taxes probably does you no good (though in some cases, taxpayers with capital gain income can get a benefit even if they are in AMT).

- If you are prepaying federal taxes, you have to live in Iowa or another state that allows a deduction for federal taxes paid.

- Of course, you have to expect to owe some taxes.

Assuming you meet these conditions, you still have to take into account that by prepaying taxes you are giving up interest you could otherwise earn on the money. The chart below measures whether getting the deduction sooner is worthwhile at different tax brackets, assuming that you can take the deduction in either year; a green number means prepayment is good.

prepaychart.JPG

As you can see, prepaying your 4th quarter taxes always pays if the deduction counts in either year. The value of prepaying declines as the ultimate due date of the return goes further out, and it never makes sense to prepay a tax due next September, like your second 2010 Iowa property tax payment.

Of course, the chart doesn't tell the whole story. You have to apply some common sense. For example, if you know you will be in AMT next year, you may want to pay a bunch of state taxes this year because the value of the deduction next year is probably zero. Unless, of course, that triggers AMT this year.

This is another installment of our exciting 2009 Year-end tax tips series!

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