Estimated Taxes and the Estimated Tax Penalty
How Much Estimated Tax Should You Be Paying?
Paying estimated taxes ensures that you're giving the Internal Revenue Service (IRS) enough money during the year to avoid owing a lump sum at filing time—or incurring penalties. Taxpayers should consider making estimated tax payments if they earn certain types of income that aren't subject to tax withholding, such as self-employment income, rental income, investment income, and capital gains.
You might want to consider making estimated tax payments in 2021 even if you don’t have any of these types of income. These payments can also cover taxes you might owe but didn’t have withheld from unemployment compensation income, or income earned because you picked up a side gig.
Who Should Pay Estimated Taxes?
No law or rule prohibits you from paying estimated taxes. You can do so if some unforeseen circumstance cropped up during the tax year that makes you think the taxes withheld from your paychecks might not be enough. The IRS will send you any excess as a tax refund if you end up paying too much.
The IRS does set requirements for which taxpayers generally must make estimated payments, however. The rule is that you should do so if you expect to owe $1,000 or more when you file your 2020 tax return in 2021.
Estimated Tax Payment Deadlines
Estimated tax payments have quarterly due dates throughout the year. Penalties and interest can apply if you pay after these dates:
- April 15
- June 15
- Sept. 15
- Jan. 15
You can make your payments monthly instead if you want to include a fixed amount in your monthly budget. You can also adjust your next monthly estimated payment to cover the shortfall if you have to skip one.
The Estimated Tax Penalty
The penalty for unpaid estimated taxes typically applies if you don't make sufficient estimated payments by the quarterly due dates, and it turns out that you should have when you file your tax return. You can usually avoid paying a penalty if it turns out that you owe less than $1,000 when you file, or if you’ve made estimated payments equal to 100% of your total tax due on your previous year’s return, whichever is less.
The penalty is essentially an interest charge, and the IRS sets the rate each quarter at the federal short-term rate plus 3 percentage points. The interest rate for underpayments by individual taxpayers was 3% in the fourth quarter of 2020, and it will stay the same for the first quarter of 2021.
Interest compounds daily and is typically added to any unpaid tax from the time the payment was due until the date the tax is paid.
How to Calculate Your Tax Payments
Look at last year's tax return to find your total tax liability, then subtract any withholding you expect to pay or have paid for this year from other income sources. You can subtract last year's withholding amount if your withholding will be about the same. The difference is the amount of tax that you should pay through estimated tax payments.
You can simply divide your expected shortfall by four to get your quarterly estimated tax payment. Divide by 12 if you’d prefer to remit estimated payments monthly. This method works if you haven't experienced any major changes since last year: You're earning about the same amount and still have the same marital status and the same number of dependents.
Divide by the number of quarters or months remaining in the tax year if you’re beginning to make estimated payments later in the year.
IRS Publication 505 and Form 1040-ES provide worksheets to help you calculate what you'll likely owe in estimated taxes. Using these worksheets might be your safest option if you've experienced multiple or significant changes.
Calculate Your Income
Let's look at an example. Joe Taxpayer is an independent contractor and his business is his only source of income. He has $25,000 in self-employment income and $7,500 in business expenses in the first quarter (three months) of the year, resulting in a net profit of $17,500.
Joe’s business isn't seasonal, so it's safe to say that his income and expenses will be similar throughout the remaining nine months of the year. Multiplying his net quarterly profit of $17,500 by four indicates that his net profit for the full year will be $70,000.
His income will be subject to both the income tax and the self-employment tax because he’s an independent contractor, so his taxable income for the year would break down like this:
- Self-employment tax: $9,890 ($70,000 x 0.9235 x 15.3%)
- Deduction for half of the self-employment tax: $4,945
- Standard deduction for a single person: $12,400
- Taxable income: ($70,000 – $4,945 – $12,400) = $52,655
This standard deduction applies to the 2020 tax year, the return filed in 2021. Standard deductions tend to change annually to keep pace with inflation.
Calculating Your Estimated Payments
Based on the tax brackets for 2020 for a single person, we can calculate Joe’s estimated income tax:
- 10% on his income up to $9,875: $987, plus
- 12% on his income from $9,876 through $40,125: $3,629, plus
- 22% on his income from $40,126 through $52,655: $2,756
These amounts add up to a total estimated income tax of $7,372.
Adding this estimated income tax to Joe’s self-employment tax of $9,890 gives us the amount he should make in estimated payments over the course of the year: $17,262. This works out to $4,315 in quarterly estimated taxes, or $1,438 if he wants to pay monthly.
How to Pay Your Estimated Taxes
You can remit estimated payments by check or credit card, or you can use the Treasury Department's online bill payment system.
Paying by Check
Make your check payable to the "United States Treasury." Be sure to write your Social Security number and the year for which you're paying in the memo field of the check; for example, you might write "2020 Form 1040-ES, 123-45-6789."
Make sure to use the payment vouchers that come with Form 1040-ES. Mail your check along with a Form 1040-ES voucher to the IRS. The IRS publishes a list of addresses on its website that vary by your state of residence.
Paying by Credit Card
The Electronic Federal Tax Payment System
The Treasury Department also operates two online payment systems. One is the Electronic Federal Tax Payment System (EFTPS). You’re required to register and create an account, but then you can simply indicate the dollar amount and the date you want the payment withdrawn from your bank account.
EFTPS users can print out a report showing all their estimated payments for the year, which is handy to have at tax time. The system can take a few days to process new enrollments, but you can schedule estimated payments from your checking account very quickly once you're set up.
IRS Direct Pay
The second online payment system offered by the Treasury Department is Direct Pay. It's designed to handle payments of personal income tax only. The service doesn’t require registration or enrollment, but you'll have to enter your personal information each time you want to make a payment.
Both EFTPS and Direct Pay enable people to schedule federal tax payments from a checking or savings account.
Another Option: Withholding More From Other Income
If you also have income that's subject to withholding, you can adjust withholding from those paychecks to cover estimated taxes on additional income. Just fill out a new Form W-4 to tell your employer how much additional tax you want withheld from your regular pay.
The IRS issued a revised Form W-4 for 2020 to accommodate the tax law changes made by the Tax Cuts and Jobs Act (TCJA), so this process is much easier. You can simply indicate an additional dollar amount that you want your employer to withhold from each paycheck. You don't have to provide a reason or explain why you're doing this if you'd rather not.