Estimated Taxes 101: A Complete Guide
Are you frequently assessed penalties by the IRS for underpaying taxes? How about if you consistently have a large balance due?
Both of these situations may indicate the need to file estimated tax payments throughout the year. The IRS required estimated tax payments for various individuals, making it critical to look at your tax situation to fully understand your obligation.
This guide will dive into everything you need to know about estimated tax payments.
What are Estimated Taxes?
Estimated tax payments are payments paid to federal and state governments based on income.
According to the IRS, “taxes must be paid as you earn or receive income during the year either through withholding or estimated tax payments” (IRS).
Salaried employees generally don’t have to worry about estimated tax payments since they have taxes take out each pay-period, however, self-employed individuals and business owners do.
The payments remitted cover all tax liabilities, from capital gains and prizes to self-employment and pass-through business income.
Who Needs to File Estimated Taxes?
Understanding your obligation to file estimated tax payments ahead of time will help you avoid any fines and penalties.
Self-employed individuals and partners or shareholders of a company often have pass-through income that is reported on the individual return, making them the top two groups that need to file estimated taxes.
The IRS requires estimated tax payments if both of the following conditions are met:
You expect to owe $1,000 or more in the current year.
You expect your withholding to cover less than 90% of the tax due on the current year return or less than 100% of the tax calculated on the prior year return.
If both of those conditions apply, you need to file quarterly estimated tax payments to avoid fines and penalties.
The IRS does give leniency to certain income groups, such as farmers and fisherman. However, they are stricter with high income taxpayers, requiring 110% of the prior year taxes to be paid ahead of time if your adjusted gross income is above $150,000 for married filing joint taxpayers and $75,000 for single taxpayers.
If the following three conditions are met, you are generally exempt from the estimated tax payment requirement:
You had a refund in the prior year.
You were a US citizen for the entire year.
The last filed tax return was for a full 12-month period.
As confusing as these requirements may seem, it is critical you uncover if estimated tax payments apply to your situation.
Sometimes it’s better to overpay than underpay and risk stiff fines and penalties.
How Do I Calculate My Estimated Taxes?
Your quarterly estimated tax payments can be determined through using Form 1040-ES on the IRS website.
This form outlines all the current requirements and regulations imposed by the IRS. For self-employed individuals, you need to take your expected net income (income minus expenses) and multiple that by one-half of the self-employment income tax rates, which ends up being 7.65%. This is self-employment taxes you will pay on that income, but you will also be taxed at ordinary income rates as well.
To uncover your ordinary income tax burden, you will need to find the current tax tables for the federal and applicable states. Once you determine your total tax, divide that number by 4.
There are many online tools that can calculate this for you.
For individuals with large amounts of pass-through income or high levels of investment income flowing through their return, the estimated tax calculation is a little simpler.
You can bypass the self-employment tax calculation and go right to the tax tables to figure out your tax burden. Keep in mind that certain investment income is taxed differently, such as capital gains taxed at capital gain rates, so the total estimated liability you find won’t always accurately represent your burden.
Perhaps the simplest method yet is to work off your prior year tax return and estimate up.
The IRS calls this Safe Harbor basis, which basically means you are paying in the required amounts to avoid penalties, which is generally 100% or 110% of the prior year total tax.
Look at last year’s return and take your total tax before any credits and payments and divide that number by 4. Any large increases in income will then be added onto the estimated tax payment.
When are Estimated Taxes Due?
Estimated taxes are usually paid on a quarterly basis, however this can differ amongst individuals.
Let’s say you have a large refund that you are applying to next year’s taxes, you might then choose to skip the first quarter payment. Other reasons for skipping a quarter include a sharp decline in income but be sure you are still paying in the Safe Harbor basis.
The first quarter payment is due April 15, the second on June 15, the third on September 15 and the fourth on January 18 of the next year.
If the due date falls on a weekend, taxpayers will have until the next business day, but it is good practice not to push payments out that long. You should strive to pay estimated tax payments around a week in advance to ensure ample processing time.
Additionally, the tax liability you calculate on your return needs to be paid by April 15 regardless of if an extension is filed so expect to have multiple payments in April.
How Do I File My Estimated Taxes?
Paying estimated taxes can be done online, by phone or through the mail.
The most common and secure way is to remit these payments online through the IRS EFTPS portal. You must pay with a card or electronic check when using this method.
Paying by phone is less common but can be done by calling EFTPS customer service.
Remitting payments through the mail can take extended amounts of time and remains unsafe, which is why many individuals stray away from this method.
However, if you do need to pay estimated taxes through the mail, make sure you attach the correct voucher and a check.
Sending cash through the mail is highly discouraged.
Also, you need to be sure you are sending the check to the correct IRS location when utilizing the mail method.
What are the Penalties for Underpaying?
Failure to pay correct estimated tax payments can result in an underpayment of estimated tax penalty.
This penalty is levied around 3.4% of the total tax bill owed. The penalty slightly lessens if payments are made prior to April 15. Remember that individuals won’t be assessed this penalty if Safe Harbor basis is followed.
Moreover, individuals are potentially able to reduce the penalty amount by annualizing their income, which is generally just taking income for each quarter in relation to the payment that was made.
Summary
Estimated tax payments can be a confusing area of taxation to understand, especially if this is your first year filing.
If you read through the entire guide and still have questions, the IRS website is filled with resources to assist you on every detail of estimated taxes.
Don’t be afraid to reach out to a professional as well. Odds are they’ve handled estimated taxes a time or two and can accurately lead you on the right path and some may even file the forms on your behalf.
No one wants to pay additional fines and penalties on top of the taxes they do owe, making it essential that you effectively plan and accurately file estimated taxes.
Sources
IRS. “Estimated Taxes.” IRS, 6 August 2021, https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes. Accessed 4 January 2022.
