Estimated tax payments — a necessary evil
Quite often, I hear people complain (you know who you are) about having to pay quarterly estimates. This is especially true with taxpayers who are either self-employed or employed with multiple types of income, such as rents, flow-through income from S corporations or LLCs, interest, dividends or capital gains.
What’s all the fuss about estimated tax payments? Why are individuals required to pay them? How are they calculated?
The answer, of course, lies in the details. This is the first part of a two-part series on estimated tax payments covering the what, who and how of this necessary and complicated “evil.”
First, the IRS requires you to pay your taxes throughout the course of the year as your income is earned, not just after the end of the year when you file your tax return. This is called the “pay as you go system” and it ensures that the IRS gets paid now, not later.
Estimated tax is simply another way to pay your taxes “as you go” throughout the course of the year. This is different from withholding tax, which is the tax that is withheld out of your paycheck and sent directly to the IRS. If you have other types of income other than wages, payments to the IRS through withholding from your paycheck may not be enough to cover your entire liability. For those that are not “employees” nor on payroll, there is no option to withhold. That creates the need to pay quarterly estimates.
Estimated payments are not always required. So how do you know if you need to make them? The IRS requires you to make estimated tax payments if:
- You will owe at least $1,000 on your return when you file and
- Your withholdings and refundable credits will be less than 90 percent of your current year tax liability or
- Your withholdings and refundable credits will be less than 100 percent of the tax liability shown on your prior-year tax return. (For taxpayers with greater than $150,000 of adjusted gross income, the percentage increases from 100 percent to 110 percent.)
In plain English, this means that if you don’t have anything paid in through withholdings, or if you don’t pay in enough through withholdings to satisfy certain “safe harbors,” then you are required to make quarterly estimates.
Now, you may be wondering why you’ve never paid quarterly estimates. Perhaps you always owe at the end of year and never receive a tax refund. This may explain why this is the case. My advice is to contact your tax preparer and ask if you should be making estimated tax payments.
Next month, we’ll provide insight on the specifics of how to calculate your payments and how much is “too much” to pay.