ESTIMATED TAXES - COMMON QUESTIONS
If you are self-employed or receive significant amounts from investments, a side job, or other sources, you may have to pay estimated taxes. Knowing the rules can help you avoid paying too much or paying too little and facing an IRS penalty.
If you are an employee, your employer withholds income taxes from each paycheck. Usually, that's enough to take care of your income tax obligations. But if you are self-employed or make a lot of money on your investments, you may need to make estimated tax payments every quarter, rather than wait until you file your annual tax return. Here's how estimated taxes work.
- What are estimated taxes?
- How do I calculate my estimated taxes?
- What if my income has jumped?
- How should I track what I've paid?
- What Forms Do I Need to Determine My Estimated Taxes?
- When are my estimated taxes due?
- When can I avoid paying estimated taxes?
- Are there any reasons to pay the penalties?
What Are Estimated Taxes?
If you are self-employed, or sell some investments at a substantial gain, you may need to pay estimated taxes. This is because taxpayers are really on a pay-as-you-earn basis. The IRS wants its money as you earn it during the year rather than waiting for you to file your annual returns.
The boss takes care of this for employees by withholding part of your wages and shipping it off to the government to pay income, Social Security and Medicare taxes. If most of your income consists of wages, you generally do not have to worry about paying estimated taxes. Instead, you simply need to make sure your employer withholds enough. However, if you earn significant money outside of your job, you probably need to pay estimated taxes.
If you're self-employed, you must estimate Social Security taxes, Medicare taxes, and income taxes due on your earnings every quarter and send the IRS a check. If you have significant income from investments, alimony or retirement plan payouts, you may owe estimated income taxes on that income (but not Social Security and Medicare taxes). If you postpone payment until your income tax return is due, the IRS will charge penalties and interest if your underpayment is large enough.
If you don't make those payments on time, you could face a penalty even if your return shows you deserve a refund.
How Do I Calculate My Estimated Taxes?
In most cases, you must make estimated tax payments if you expect to owe $1,000 or more in taxes for the year - over and above the amount withheld from your wages. In some cases, though, the $1,000 trigger point doesn't matter.
- If your prior year adjusted gross income was $150,000 or less, then you can avoid a penalty if you pay either 90 percent of this year's income tax liability or 100 percent of your income tax liability from last year (dividing what you paid last year into four quarterly payments). This rule helps if you have a big spike in income one year, say because you sell an investment for a huge gain or win the lottery. If wage withholding for the year equals the amount of tax you owed in the previous year, then you wouldn't need to pay estimated taxes no matter how much extra tax you owe on your windfall.
- If your prior year adjusted gross income was greater than $150,000, then you must pay either 90 percent of this year's income tax liability or 110 percent of last year's income tax liability.
Note: If you are a farmer or a fisherman, replace the 90 percent shown above with 66.67 percent. Because many special rules apply to farmers, refer to IRS Publication 225: Farmer's Tax Guide for additional information.
What If My Income Has Jumped?
Most people pay just over 100 percent of their prior-year income tax liability as long as their business income doesn't change dramatically. But even if you pay 100 percent (or 110 percent as the case may be) of your prior year income tax, you may discover that you still owe more money to the IRS when you prepare your income tax return, even though you are exempt from the estimated tax underpayment penalty.
In fact, if your business income has increased substantially, you might owe a considerable amount of additional income tax, another aspect of success.
To avoid having to write large checks to both the IRS and your state when your income tax return is due, you may want to pay additional estimated taxes ahead of time, even though you have paid in enough to avoid a penalty. That may give you peace of mind. By doing so, you're sending the IRS funds that it will eventually receive. But you're also reducing your working capital. So, you lose the chance to invest these monies until your income tax return is due.
How Should I Track What I've Paid?
After you start paying estimated taxes, be sure to keep a separate record of the dates you paid them and how much you sent for each period. If you don't keep accurate records, it can take you longer to prepare your income tax return and you may miss one or more of the payments you made. If you pay estimated taxes, be sure to claim credit for them when you file your income tax return.
What Forms Do I Need to Determine My Estimated Taxes?
For estimated taxes, use Form 1040-ES: Estimated Tax for Individuals. Form 1040-ES includes a worksheet to help you determine your estimated tax.
When Are My Estimated Taxes Due?
Never accused of oversimplifying things, the IRS doesn't break the tax year into four three-month quarters. The first quarter is three months (January 1 to March 31), but the second "quarter" is two months long (April 1 to May 31), the third is three months (June 1 to August 31) and the fourth covers the final four months of the year.
The installment payments are due on April 15, June 15, September 15 and January 15 of the following year. You can skip the final payment if you will file your return and pay all the tax due by February 1. If a due date falls on a weekend or legal holiday, the deadline is pushed to the next business day.
You don't have to make any payment until you have income on which estimated taxes are due. If you know early in the year that you must make estimated payments, each of the four payments should be 25% of the amount due.
But what if you receive income during the third quarter that, for the first time, makes you liable for estimated tax payments? Your first payment would be due on the third installment date (September 15) and you are expected to pay 75% of the tax that is due.
To hold your payments to a minimum, base each installment on what you have to pay to avoid the penalty, using any exceptions that benefit you.
If you have a tax refund coming from the IRS, you can elect on your return to have part or all of the money applied to your estimated tax bill. Although the IRS doesn't pay any interest on such advance payments, it may make sense to use the refund to pay the first installment (due April 15) and perhaps even the second (due June 15) just to save yourself the hassle of writing and sending in the checks.
After you send in an estimated tax payment with its payment voucher, the IRS will automatically send you a package of pre-printed vouchers showing your name, address and Social Security number. The payments are made to the IRS service center for your area.
Also note: If at least two-thirds of your gross income is from farming or fishing, you have only one estimated tax payment for the year, which is due by January 15 of the following year. You can even skip making the single estimated tax payment as long as you file your tax return by March 1 and pay in full any tax due.
When Can I Avoid Paying Estimated Taxes?
If you expect to owe less than $1,000 in income tax this year after applying your federal income tax withholding, you don't have to make estimated tax payments.
If all your regular income comes in salary and your employer is withholding taxes on your pay, you should not need to pay any estimated taxes unless you suddenly strike it rich by selling stock at a large profit or winning the lottery.
If you start a side business (and you report your income from that business on Schedule C) while continuing to work for an employer who withholds from your paycheck, you may be able to increase your withholding so that it equals what your tax liability would be for the entire year or is enough to meet the exception for last year's tax liability that we told you about earlier. In that case, you will not need to pay estimated taxes on your side business.
Are There Any Reasons to Pay the Penalties?
We can't think of any good reason. Ignoring the rules might save you some time during the year, but you'll pay the piper come April.
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