By Lyzz Leise
For many employees, paying taxes happens largely behind the scenes. Their employer withholds federal income tax from each paycheck and sends that money to the IRS throughout the year. But what happens when no employer is withholding taxes for you, or when your withholding is not enough to cover income you receive from other sources? Business owners, self-employed individuals, partners, S corporation shareholders, and people with significant investment or other non-wage income may need to make estimated tax payments during the year. Estimated payments can cover federal income tax as well as certain other federal taxes, including self-employment tax.
For this week's Tuesday Tax Take, we are breaking down why estimated taxes exist, who may need to pay them, and what can happen if you simply wait until tax season to pay the IRS.
The Federal Tax System Is “Pay As You Go”
Although we generally think of April 15 as “Tax Day”, the federal tax system is designed so that taxes are paid throughout the year as income is earned or received. Employees usually satisfy this requirement through payroll withholding. When income is not subject to withholding, or when existing withholding is not sufficient, taxpayers may instead need to make estimated payments directly to the IRS.
Common examples of income that may create an estimated tax obligation include:
Self-employment or business income;
Income passed through from a partnership or S corporation;
Interest and dividends;
Capital gains;
Rental income; and
Other income for which sufficient federal tax is not withheld.
Receiving one of these types of income does not automatically mean estimated payments are required. The question is whether enough tax is being paid throughout the year through withholding, estimated payments, and applicable credits.
Who Generally Needs to Make Estimated Payments?
Generally, an individual may need to make estimated tax payments if both of the following apply:
The individual expects to owe at least $1,000 in tax for the year after subtracting withholding and applicable credits; and
The individual's withholding and credits are expected to be less than the smaller of:
90% of the tax ultimately owed for the current year; or
100% of the tax shown on the prior year's return.
For taxpayers whose prior-year adjusted gross income exceeded $150,000, or $75,000 if married filing separately, the prior-year threshold generally increases from 100% to 110%. These rules are commonly referred to as the estimated-tax safe harbor rules. In practical terms, the safe harbor gives taxpayers a way to determine how much generally needs to be paid during the year to avoid an underpayment penalty, even when the exact final tax bill is not yet known. There are several exceptions and special rules. For example, a taxpayer who had no tax liability for the prior year may not be required to make estimated payments if certain requirements are satisfied. Special rules also apply to certain farmers and fishermen and in other circumstances.
When Are Estimated Taxes Due?
Despite commonly being called “quarterly” taxes, the estimated-tax payment periods are not four equal three-month quarters. For calendar-year taxpayers, estimated tax payments are generally due:
April 15;
June 15;
September 15; and
January 15 of the following year.
If a due date falls on a weekend or legal holiday, the deadline generally moves to the next business day. Taxpayers whose income fluctuates significantly during the year may also have additional options. For example, someone who receives a large portion of his or her income later in the year may be able to use the annualized income installment method, which takes into account when income was actually earned rather than assuming income was received evenly throughout the year.
What Happens If You Just Wait Until April?
This is where estimated taxes can catch taxpayers off guard. Paying the entire tax bill when the return is filed does not necessarily eliminate the problem. Because taxes generally must be paid throughout the year, the IRS may assess an underpayment penalty when sufficient tax was not paid by the applicable payment deadlines. In fact, a taxpayer may potentially owe an underpayment penalty for an earlier payment period even if the taxpayer later catches up on payments or ultimately receives a refund when the annual tax return is filed. This is one reason tax planning during the year can be particularly important for business owners and others whose income does not come entirely through a traditional paycheck.
Estimated Taxes Are Not Just for the Self-Employed
A taxpayer can have a regular W-2 job and still need to think about estimated payments. For example, estimated taxes may become relevant when someone:
Sells stock or another investment and realizes a significant capital gain;
Receives significant income through a partnership or S corporation;
Begins earning substantial income from a side business;
Receives significant interest or dividend income; or
Has other income that is not subject to sufficient withholding.
For taxpayers who also receive wages, increasing the amount withheld from their paychecks may sometimes be an alternative to making separate estimated tax payments. The appropriate approach depends on the taxpayer’s particular circumstances.
The Takeaway
Estimated taxes are essentially a way of making sure taxpayers pay federal taxes throughout the year rather than waiting until their annual return is filed. If you own a business, are self-employed, receive pass-through income, have significant investment income, or experience a major financial event during the year, it may be worth checking whether your existing withholding and payments are sufficient. A little planning during the year can help prevent an unexpected tax bill and potential underpayment penalties when tax season arrives. As with most tax rules, there are exceptions and special circumstances, so taxpayers should consult with their tax advisor regarding their particular situation.
This article is provided for general information purposes only and should not be construed as legal advice. Those requiring legal advice are encouraged to consult with their attorney.
