Estimated Taxes: What Are These? Do I Need to Pay Them?
Do estimated taxes confuse you? Don't worry, you are not alone. We’ll do our best to clear up the confusion.
Do I Need to Pay Estimated Taxes?
Income taxes in the US are a pay-as-you-go system, meaning you are required to pay taxes on your income throughout the year (in quarterly installments) rather than paying a lump sum on April 15th. If you don't pay them throughout the year, then you will be charged interest. This is true for federal and state income taxes.
In any given year, you should pay estimated taxes if both of the following apply:
Your total federal income tax bill for the year is $1,000 or more after paycheck withholdings and refundable credits.
Your paycheck withholdings and refundable credits are less than 90% of your current year tax or 100% of your prior year tax (110% of prior year if your AGI is above $150,000 or $75,000 for married filing single).
Common Situations That May Require You to Pay Estimated Taxes:
You are self-employed and your net income is above $3,000. Self-employment taxes of 15.3% add up quickly!
You receive income from interest, dividends, or capital gains
You own rental properties
You receive income from a partnership, S-corp or other business interests
You are W-2 employee, but don't have enough withheld from your paycheck. A common area of confusion is that your withholdings should cover all of your taxes. This is not necessarily true. Check your withholdings with the IRS calculator here.
I Have No Idea How Much to Pay. What Should I Do?
The IRS offers something called the Safe Harbor Method to handle this uncertainty.
Safe Harbor Method Based on Prior Year Tax – The Easy Option
If you pay in 100% of your prior year tax throughout the year (110% if your AGI is above $150,000 or $75,000 if you are married filing separately), then you won't owe interest on any tax still due come filing time.
(1) You won't owe interest on your taxes even if you still owe a balance.
(2) It's a very straightforward method, especially if you are using the prior year tax to make payments.
(1) If you are paying in based on the prior year and you are earning a lot more this year, then you could still end up with a large tax bill come filing time. If you are earning less in the current year, then you may be overpaying the IRS and lending them money for free.
Safe Harbor Method Based on Current Year Tax Liability – The Less Easy Option
If your earnings or deductions are fairly different than the prior year, then estimating your current year tax liability may be the best method. The IRS Form 1040-ES and the handy Estimated Tax Worksheet are designed to help you do this. Don’t worry, I can vouch, the worksheet is as fun as it looks! If you aren't sure that you want to spend your weekend reading tax instructions, then give us a call! We are always happy to assist with estimated tax analyses.
Self-Employment “Rule of Thumb”
If you are self-employed, you may have heard of this option. It's not official IRS guidance, but just a very general and rough rule of thumb to set aside 30% of your income (profit) for estimated taxes. This figure can be accurate for some taxpayers, but it depends on your specific situation and does not protect you from underpayment penalties if it isn’t accurate. The other risk is that you may end up overpaying depending on your circumstances.
When and How Do I Give My Money to the IRS? (Never thought I’d say that…)
You’ve made it this far, we’re almost there!
Quarterly due dates for estimated tax payments are generally as follows for the current year:
For instance, in 2021 you will owe your first estimated payment on April 15th, 2021. The IRS prefers four equal quarterly payments, but if your income is uneven throughout the year you can vary your payment amounts by using Schedule AI in Form 2210.
Last of all, where should you send your payments? The easiest way to send money to the IRS is to pay online. You can pay via direct debit or even credit card, although there is a fee.
Do you prefer snail mail? Then look to Form 1040-ES for the appropriate mailing address and payment voucher. We also suggest sending your payment at the Post Office via Certified Mail Return Receipt. This way you’ll have a stamped receipt mailed back to you to keep in your records as proof that you mailed the payment.
Feeling Overwhelmed or Have No Appetite for This Topic?
We’d be happy to assist with calculating your estimated tax payments and/or offering any tax planning services to help you navigate this confusing part of the tax world and minimize your tax bill. Schedule your free consultation today!