Do you owe estimated taxes?
The US tax system is a pay as you go system, which means you are supposed to pay taxes as you earn income. This isn’t a problem for many people because their employers withhold their taxes from their paycheck. But if you do not have enough money withheld from your paycheck or if you have additional income from self-employment, investments, real estate, or other means, you may need to pay self employment tax or make estimated tax payments.
Who Needs to Pay Estimated Taxes?
The money employers automatically withhold from your paycheck is sent in to the IRS and your state if you live in a state that assesses income tax. Ideally, the exact amount of money would be withheld and you won’t end up owing any money or receiving a tax return. However, it’s not always easy to predict your year end income or which deductions you will have throughout the year, particularly if you have unsteady income. Because of this, many entrepreneurs have to deal with self-employment and estimated taxes.
You must pay estimated tax if both of the following apply:
- You expect to owe at least $1,000 in taxes after subtracting your withholding and credits.
- You expect your withholding and credits to be less than the smaller of;
- 90% of your current year tax liability, or
- 100% of the tax shown on your previous year’s tax return.
In other words, the amount of estimated taxes you need to pay to avoid penalties is the smaller of 90% of what you will owe this year, or at least 100% of what you owed last year (110% for high income earners).
Who Does Not Have To Pay Estimated Tax
You should not have to pay estimated taxes if you will owe less than $1,000 in taxes this year, or if your employer withholds enough money through your paychecks. You can adjust your W-4 to withhold more or less money depending on your personal situation. Use the IRS Withholding Calculator to determine how many dependents you should claim, which will affect the amount of taxes withheld from your paycheck.
How To Determine How Much Estimated Tax to Pay
If you have steady income that is not subjected to automatic tax withholdings, or if you have a fairly good idea how much money you will earn in a given year, you can determine how much estimated taxes to pay with estimated tax worksheets or software. IRS Form 1040-ES includes a worksheet to calculate how much you should pay for your estimated taxes. You can also find calculators in most commercial tax software programs like TurboTax and H&R Block Online (H&R Block Review).
Irregular income? It can be difficult for individuals with irregular income to predict how much they will earn in a given year. Thankfully there is a safe harbor rule, which states that as long as you pay 100% of your previous year’s total tax liability in withholding and/or estimated taxes, you’ll be exempt from underpayment penalty regardless of your final tax amount (remember the 90% of current year or 100% of last year rule from above?).
A simple way to qualify for the safe harbor rule. To qualify for the Safe Harbor Tax Rule and avoid penalties, take your previous year’s tax obligation, divide by four, and make four equal payments by the estimated tax deadlines. Add 10% to last year’s tax total if you are a high income filer.
How much per installment? The IRS wants estimated taxes to be paid in equal installments, regardless of when you earn your income. This can be tricky when you don’t know how much you will earn, or if you typically have lean months in the beginning of the year, and earn more money in the latter part of the year. The easy way to avoid this is to follow the safe harbor method mentioned above. But if you want to do it a different way, then I recommend this article about calculating your estimated tax payments.
How I Determine My Estimated Tax Obligations
My accountant bases my estimated taxes based on my previous year’s income, which is how many people calculate their estimate taxes. However, you may wish to reassess your calculation as your year progresses. You may find that your income situation is very different from the previous year and you may end up owing more or less than your estimated tax payments justify. If you owe more, then you can wait and pay them when you file your taxes, as long as you meet the safe harbor minimum as described above. But if you pay too much, you may end up receiving a large tax refund. I recommend consulting with a tax professional if you plan on changing your estimated tax payments during the year.
Estimated Tax Deadlines
Estimated taxes are due four times per year on the dates listed below, or the following business day if the due date falls on a weekend or holiday. (Note the due dates are not spaced exactly 3 months apart):
- April 15th
- June 15th
- September 15th
- January 15th
Note: You must still pay your estimated taxes by the deadline, even if you have filed an extension on your taxes.
How to File and Pay Your Estimated Taxes
There are two ways you can file and pay your estimated taxes: by paper or electronically.
- Pay by mail. Use IRS Form 1040-ES (download pdf here) to calculate your estimated taxes. Then fill out a voucher on the form to send along with your estimated tax payment.
- Pay Electronically. If you prefer to pay your taxes electronically, you can sign up for the Electronic Federal Tax Payment System (EFTPS) to pay your estimated taxes online. It can take up to 2 weeks to receive your PIN in the mail, so plan accordingly.
I usually pay my estimated taxes by mail each quarter. My accountant gives me the estimated tax vouchers for the next year. I place them in a large manilla envelope and set calendar reminders to make the payment and send in the check. You can do the same thing electronically. Either way, the key is to be organized and not miss your scheduled estimated tax payment. Failing to make your payment can lead to penalties and/or fees.
Here are more tips for organizing your tax documents.
Consult a professional for more details
The information in this article should give you a decent overview of how estimated taxes work and how they might apply to your situation. But keep in mind that each situation is unique and this may not cover all people and situations. Your specific tax situation may be different; please consult an accountant or IRS documentation for information specific to your needs.
Another note – be sure your tax preparer is properly licensed in your state. In California, they are required to get a “tax preparer bond” to protect you from a preparer’s misstatements, misrepresentations, dishonesty, fraud, deceit or any other unlawful acts or omissions. This is just one layer of protection that comes along with licensing.
Additional IRS Resources:
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Bryce @ Save and Conquer says
My wife and I get enough dividends in our taxable investments at the end of the year that it is wise for us to make an estimated tax payment before Jan 15. We’ve done that for the past decade, and things work out well on April 15 with us owing the IRS a few hundred dollars, and the state usually owing us a hundred or so.
Ryan Guina says
That’s a great point, Bryce. Many people only think of estimated taxes for self-employment income. But it’s important to remember that estimated taxes may be due for investment income and other forms of income.
Jared says
Ryan,
I started a new job this year. My boss, who owns the company hadn’t decided whether I would be treated as a contract worker or employee until a few weeks ago. He decided to treat me as an employee, however, for the first seven months or so no taxes have been taken out of my check nor have I made estimated tax payments. Will I be penalized for not making estimated payments? What should I do? Thanks!
Ryan says
Jared, this is a situation I am not familiar with. You probably need clarification from your employer regarding when your offical start date was as an employee because your employer is required to pay unemployment insurance and other taxes for all employees, as well as the employer portion of employment taxes. Then you will need to pay your taxes based on your employment status. I recommend sitting down with your employer to get this situation resolved as quicky as possible (it may also be a good idea to contact an accountant to help you better understand your options). And on your end, it will be a good idea to start saving some money in case you end up with a big tax bill.
Pat S says
This article is helpful, and if Sam hadn’t asked the question above I might have! The best thing in your response- “speaking with a small business adviser or accountant”. The tax code is so complex that trying to do this kind of stuff on your own is only begging for an audit… IMHO
Sam says
Hi Ryan,
What if you have a day job and make $200,000 and have normal taxes withheld, and earn an irregular income of maybe $30-80,000. Do you still have to pay estimated taxes on that side income?
Also, what if you launch in February, and have no idea what your side income will be that first year, but for 3 months you have a sense. Do you still pay, or can you wait a fair full year cycle to get a better sense?
Thx!
Sam
Ryan says
Great questions, Sam, and I’ll answer to the best of my ability (and recommend you verify with a tax pro or otherwise follow up with your own research before acting).
Irregular income + day job: If your irregular income is a pass through entity (sole proprietor, single person LLC, etc), then it’s essentially one pot of money. If this is the case, all the IRS is concerned with is that you pay enough taxes, and pay them on time. The US tax system is a pay-as-you-go system, which means you owe income tax when the money is earned. The good thing is that the IRS considers payroll withholdings as spread throughout the year, so if you backload your withholdings from your day job at the end of the year, then you should be covered. You can also increase your estimated tax payments at the end of the year if a lot of your side income comes near the end of the year. This would be common for a new business which might not have a lot of revenues at the beginning of the year, but which could increase as the year progressed.
Regarding a new business: You would still have to pay estimated taxes on the income, but as previously mentioned, you could pay only what you owe, when you owe it. The tax system is a pay-as-you-go system, so if your earnings at the beginning of the year are light, then you wouldn’t owe much. The other thing to be aware of is safe harbor laws, which basically state that as long as you pay X-amount above your previous year’s tax obligation, then you will be OK in the eyes of the IRS.
Finally, day job income is pretty straight forward, but if you are dealing with self-employment or small business income, I highly recommend speaking with a small business advisor or accountant – they can explain these details as they apply to your situation and often help you find ways to save money. I use an accountant for all my tax needs and highly recommend it (I have saved much more on taxes than I have spent on professional tax services – always a win in my book!).
RobertSeattle says
If you are paid a salary and find yourself behind on estimated taxes, and can afford it, just have lots more taken out of salary late in the year. The way the IRS calculates penalties, it “doesnt’ care” when salary based federal tax withholding occurs so it is a nice way to catch-up if you missed 1040-es payments.
I wish there was a way to pay 1040-ES taxes without the total rip-off 2.49% charged by the tax payment companies. Why can’t the IRS accept credit cards and get rid of the highway robbery middle man?
Ryan says
Robert, I did something similar last year by withholding extra from my day job instead of paying estimated taxes for my small business income. It worked out well enough, but this year I planned a little better for my situation.
You can do a free electronic transfer to avoid fees, but if you insist on paying with your credit card, then you are probably out of luck in avoiding fees.
Kirk Kinder says
@Dan: I wouldn’t worry too much about that. So long as the government gets their money they seem to be happy. I have even missed an estimated payment and made it up later in the year. Never heard a word. I know other self-employed folks who do this regularly. Again, it is better to do them quarterly, but I think the IRS just wants to make sure they get their bounty so they don’t spend a lot of time chasing after folks who are a little late on paying.
This may change as the government needs more and more revenue, but I haven’t heard of them coming after self-employed folks. Now, if you have employees, you best be on time, especially with Social Security taxes or you will get a knock at the door.
Ryan Thompson says
Ryan-
As a long time estimated taxpayer, like a lot of people I was annoyed and frustrated at the payment options: vouchers and stamps or EFTPS. I always wondered why there wasn’t an easier way? So I started a service called Easy Estimated Taxes that allows people to manage and pay their estimated taxes online. Our goal is to make the entire estimated taxes process easy. I hope you’ll consider this as another payment option.
Dan says
Question: Based on my calculations, I’m right on the border for needing to pay estimated taxes. However, my first two payments were past the April and June deadlines. Come April of 2010, if it turns out that I never really needed to send estimated payments, would I still get penalized for sending in those 2 payments late?
Ryan says
Dan, if you have salaried income, then the tax withholdings from your employer are considered to have been made in equal payments regardless of when the money was actually withheld. So if you think you may be required to pay estimated taxes, you can change your W-4 to have more money withheld from your paycheck and avoid paying estimated taxes. I had additional income withheld from my day job last year for that purpose.
As for making late estimated taxes, I’m not sure. It depends if you will fall under the safe habor rules or not. If you can increase your withholdings from your day job, then you can avoid needing to make estimated tax payments.
Matt Jabs says
Timely post for me Ryan. Now that I am earning more and more money from my blog each month… this is a practice I need to integrate into my financial life. This post definitely helps me decide how to best proceed.
Ryan says
Sept 15th is the next payment deadline, so you can always get started on that date. But you will probably be OK as long as you meet the Safe Harbor requirements.
The impending deadline is why I wrote about this topic… I realized I’ve been sending in payments, but had never written about it!
Miranda says
It’s also nice to spread the tax burden out over the year, rather than frantically trying to pay it all at once. If you have an accountant or some other professional prepare your taxes, you an usually get pre-filled out forms to send in with your payment when your estimated taxes are due. This is very helpful as well.
Ryan says
Absolutely, Miranda I never know how much income my small business will bring in on a month to month basis, much less on an annual basis. So taking the tax harbor rule into mind, it is easier to take last year’s tax obligation and divide by four, then spread out the payments equally. The vouchers are easy to fill out if you are a DIY kinda person, but there is something to be said about using an accountant! 🙂
DDFD at Defensive-Entrepreneurship says
Really solid overview. Tax payments need to be managed– even W-2 employees need to manage it. Why give the government an interest free loans?
Super important stuff for the self employed– even Defensive Entrepreneurs running side gigs!
Ryan says
I would say it is important especially for defensive entrepreneurs running side gigs. Many full-time self-employed individuals take taxes into consideration year round, but many people just starting out with a side job or other entrepreneurial effort may not know about estimated taxes or may down play their importance.
M says
What is your opinion on this situation:
I bought a house this year with 20% down 30 year fixed loan. To take advantage of the $8000 First Time Home Buyer Credit sooner rather than later, I have had my employer withhold $0 taxes over the last couple of months. Once I hit the $8000 number I turned withholding back on.
I was just going to claim the house purchase, and receive the credit, on my 2009 taxes but I’m making more this year than I anticipated and will most likely not qualify for the full credit.
My 2008 income (~30% of my 2009 income) allows me to claim the full credit and the First Time Home Buyer Credit allows me to treat my 2009 purchase as if it happened in 2008. If I file an adjusted 2008 tax return I’m concerned that I will receive penalties because I did not withhold enough in 2009.
As long as I pay enough taxes in 2009 to cover the amount in 2008, should the Safe Harbor Rule protect me from any penalties?
Ryan says
M, sorry, but I’m afraid I don’t have the knowledge to answer your question. I recommend speaking with an accountant on this topic, unless another reader can chime in?