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Estimated tax payments — a necessary evil: Part 2
Last month, we introduced the “evil” concept of estimated tax payments — what they are and who is required to make them. To review, if you don’t have enough tax paid in through your payroll withholdings, then it’s likely you will be required to make estimated tax payments.
Assuming this applies to you, the question becomes — how do I calculate my estimates and how much is “too much” to pay?
With regard to the first question, it depends (of course!). The methodology generally boils down to how much income you’re projected to make this year relative to last year. For years where income increases, the general course of action is to base quarterly estimated payments on 100 percent (or 110 percent) of your prior year tax. For example, if your prior year tax was $40,000, then you should pay $10,000 each quarter to meet the safe harbor rule to stay safe from penalty and interest.
On the other hand, for years when income decreases, then generally your quarterly estimated payments are based on 90 percent of your projected current year tax. This is a little trickier because it requires you to look at your year-to-date income each quarter, annualize that income, and then calculate your estimated tax liability. For example, on April 1 you project your tax to be $40,000 for the entire year. You are required to pay in 90 percent of the $40,000 (or $36,000) over four quarterly installments. Your required first quarter estimate is equal to 25 percent of the $36,000 (or $9,000). A similar analysis is necessary for the remaining quarters. Note the overall projected tax ($40,000 in this example) is likely to change each time you run the numbers, especially if your income varies over the course of the year. This methodology is more complicated, but it should result in you paying less to the IRS in years your income decreases.
As for the “right” amount to pay, that depends as well! The general objective of tax professionals is to have clients pay in only their legal obligation — but not a dime more — and to defer the amount due as long as possible without incurring underpayment penalty and interest. If a taxpayer pays too much, he/she will receive an interest-free refund from the IRS. If a taxpayer does not pay in enough, then he/she will owe the unpaid tax with the return as well as additional penalty and interest for failing to pay enough on time. Generally, the “right” amount to pay would be the amount that would result in no amount due to you or refund owed. But ultimately, that is a personal philosophical question with no “right” answer. It just depends!