A while back, Uncle Sam (The United States Government) realized that it would be impossible to withhold taxes from every dollar a person made. This was a problem, especially because the IRS works on a pay-as-you-go basis. As such, it was decided that taxpayers with income not subject to normal payroll withholding, would be required to pay estimated taxes. Income not subject to withholding include items such as interest, dividends, alimony, self-employment income, capital gains, prizes, awards and more.
Estimated tax payments can be a burden, but are necessary in order to avoid penalties and interest. Penalties and interest are imposed on anyone who has more than $1,000 in taxes, after subtracting withholding and applicable credits, still due on April 15th. Estimated tax payments for individuals are due four times throughout the year. The dates are:
|Estimated Tax Due||For Income Received|
|April 15th||January 1 – March 31|
|June 15th||April 1 – May 31|
|September 15th||June 1 – August 31|
|January 15th||September 1 – December 31|
The IRS allows a couple different methods in calculating estimated tax. The first method is to simply estimate the tax you will owe for the current year, divide it by four, and send in four equal payments. This method avoids penalties and interest as long as the amount sent in equals 90% or more of the amount owed for the current year.
Another method available to taxpayers is called annualization. This method allows taxpayers to pay increased taxes when they are earning more money and less when their income is down. This means the estimated taxes are based on actual income instead of an estimate. This method is ideal for:
- Seasonal workers
- People between jobs or changing jobs
- Self-employed individuals
- Anyone that incurs sizable deductions at various times during the year
If the annualization is successful, the individual will determine what their full year’s income would be if they proceeded to earn what they did for that period, and only pay tax on a fourth of that amount. This method is ideal for cash flow purposes as you pay the tax in the period in which you incur the corresponding income.
A safe harbor method can be used when a taxpayer expects that their income from the current year will be the same or higher than it was in the previous year. This method is easy to use and only requires knowledge of last year’s tax return and current withholding. By paying either 100% or 110% of their prior year’s tax liability, taxpayers who are “acting in good faith,” are protected from the penalties and interest assessments. Taxpayers that are married and have an AGI over $150,000 are required to pay 110%, while anyone making less than that will pay 100%. If the taxpayer is filing as single, the AGI amount is cut in half.
Taxpayers have the option to pay estimated taxes by paper check or by electronic filing. In order to pay electronically, taxpayers must sign up with the Electronic Federal Tax Payment System, or use the IRS’s Direct Pay option. State estimated tax payments may also be required. As such, it is important to know the requirements in the state you earn income as the payment requirements vary from state to state.
In summary, every taxpayer along with their tax advisor should assess the need to pay estimated taxes in order to avoid additional penalties or interest. If you have any questions regarding this or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.