Estimated Taxes and the Estimated Tax Penalty
How Much Estimated Tax Should You Be Paying?
Paying estimated taxes is one way to make sure you're giving the Internal Revenue Service (IRS) enough money during the year to avoid owing a lump sum at filing time—or worse, incurring penalties. Taxpayers with types of income that aren't subject to tax withholding, such as self-employment income, rental income, investment income, and capital gains, should generally consider making estimated tax payments.
Estimated Tax Payment Deadlines
Estimated tax payments technically have due dates. Penalties and interest don't apply until after these dates have passed. Payments are due quarterly on:
- April 15
- June 15
- Sept. 15
- Jan. 15
It's perfectly OK if you want to pay more frequently. You can make payments monthly if you like so a fixed amount of tax is included in your monthly budget. You can adjust your next monthly estimated payment to cover the shortfall if you have to skip one.
How Much Do You Need to Pay?
The easiest way to calculate how much you should be making in estimated tax payments is to divide last year's unfunded tax liability by four because estimated payments are made quarterly. Your unfunded tax liability is what you owed the IRS when you filed your return.
This method is quick and easy if you haven't experienced any major changes since last year: You're earning about the same and still have the same marital status and number of dependents. Just divide your shortfall by four, or by however often you want to remit estimated payments, such as by 12 if you want to do it monthly.
Another option is to look at last year's tax return to find your total tax liability, then subtract any withholding you expect to pay in for this year from other income sources. You can subtract last year's withholding amount if your withholding will be about the same as last year. The difference is the amount of tax that you should pay in through estimated tax payments.
What to Do If You've Experienced Changes
These methods don't take changes in your income into consideration, or any changes that might affect your deductions for the current year. You might have more or less income, or qualify for different tax deductions.
The 1040-ES worksheet will help you calculate the minimum amount of estimated tax you should pay to avoid a penalty. The worksheet also includes all the current year figures for standard deductions and tax rates to help you obtain an accurate figure for this year's payments.
Calculating Your Income
Let's look at an example. Shelley is an independent contractor and this is their only sole source of income. They have $25,000 in self-employment income and $7,500 in business expenses in the first three months of the year. This resulted in a net profit of $17,500.
Their business isn't seasonal, so it's safe to say that their income and expenses will be similar throughout the next nine months of the year. The first three months represent one quarter of their annual income. Multiplying Shelley's net profits of $17,500 for the first three months by four indicates that their net profit for the full year will be $70,000. They'll earn $17,500 in each of the four quarters.
Shelley's income will be subject to both the income tax and the self-employment tax because they're an independent contractor. Here's how the income calculation would work:
- Self-employment tax: ($70,000 x 0.9235 x 15.3%) = $9,890.69
- Deduction for half of the self-employment tax: -$4,945.34
- Standard deduction for a single person: -$12,200
- Taxable income: ($70,000 - $4,945 - $12,200) = $52,855
This standard deduction applies to the 2019 tax year, the return filed in 2020. Standard deductions tend to adjust annually to keep pace with inflation.
Calculating Your Estimated Payments
Based on 2019 tax brackets, Shelley's income tax is estimated to be $8,370 because they're single. This plus their self-employment tax of $9,890.69 equals how much they should make in estimated payments over the course of the year: $18,261. Shelley would have to pay at least 90% of this amount in order to avoid the estimated tax penalty, but they might also want to pay the full amount of the tax to avoid owing money at tax time.
Shelley would multiply the tax amount—$18,261—by 90%, then divide the resulting number by four to find each of their four estimated payments. They would work out to $4,109 each if they wanted to pay in just 90% of their current tax due: $18,261 times 90% divided by four.
They would take the tax amount and simply divide by four to find each of their four estimated payments if they wanted to pay 100%—about $4,565 each.
Adjusting Withholding From Other Income
You can adjust the withholding from your paychecks to cover additional estimated taxes on other income if you also have income that's subject to withholding. This might be the case if you work a regular job, but also receive income such as interest, dividends, or income from side jobs or consulting work.
The fix here is simple. Just fill out a new Form W-4 telling your employer how much you want to be withheld from your regular pay. You have two options here. One is to completely revise your W-4 with current information, including your extra income. The other is to simply indicate an additional dollar amount that you want your employer to withhold from each paycheck—you don't have to explain to your employer why you're doing this if you'd rather not.
The old Form W-4 was based on allowances that corresponded to the personal exemptions you could claim on your tax return for yourself, your spouse, and each of your dependents, but personal exemptions were eliminated from the tax code under the TCJA. The 2020 form is more a matter of answering some questions as a result, rather than calculating allowances as in years past.
Increasing Your Withholding
Let's assume that Nancy will owe $4,000 in taxes on self-employment income because they freelance in addition to their regular job. They could take this tax amount and divide it by the number of remaining pay periods in the year. The result would be entered on line 4c of the 2020 Form W-4 as an additional amount to withhold each pay period.
This additional tax will show up on their W-2 as part of their federal income tax withholding and will be applied to the total tax they owe for the year, including any self-employment tax.
Paying Estimated Taxes Directly
You can send in estimated payments by check, pay by credit card, or use the Treasury Department's online bill payment system if you can't or don't want to adjust your withholding,
Paying by Check
Paying estimated taxes by check is pretty easy. Just make sure to use the payment vouchers that come with Form 1040-ES.
Make the check payable to the "United States Treasury." Be sure to write your Social Security number and indicate the year for which you're paying in the memo field of the check, such as "2019 Form 1040-ES."
Avoid making the check payable to the "IRS" or "I.R.S." Thieves have been known to confiscate these checks and alter the name, such as to "J.R. Smith," "MRS Smith," or some other permutation. You can prevent this sort of theft by always writing out "United States Treasury" because that can't be easily altered.
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
Taxpayers have historically had to use an authorized third-party payment service to pay by credit card, at least through early 2020. These payment services processed tax payments and forwarded the funds to the IRS. They charged convenience fees, and you'd have to pay interest on top of that.
But the Taxpayer First Act, signed into law in July 2019, changed this. It allows the IRS to begin accepting credit card payments directly for the first time. This option is provided for on the IRS Paying Your Taxes webpage. Some fees might still apply.
The Treasury Department also operates two online payment systems. One is the Electronic Federal Tax Payment System (EFTPS). It can take a few days for new enrollments to be processed with the service, but you can schedule estimated payments from your checking account very quickly once you're set up.
Simply log in to EFTPS to pay your estimated taxes and schedule a payment. You can 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 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 does not require registration so you can use Direct Pay straight away, but you'll have to enter your 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.
The Estimated Tax Penalty
The estimated tax penalty typically applies if you don't make estimated payments or sufficient estimated payments by the quarterly due dates, so you end up owing the IRS at the end of the year. It's essentially an interest charge for not paying taxes throughout the year.
The IRS sets this rate each quarter. The interest rate for underpayments by individual taxpayers was 5% in the first quarter of 2020, 5% in the second quarter of 2020, and 3% in the third quarter of 2020. The IRS announced the change for the third quarter of 2020 on June 4.
The applicable quarterly interest rate is charged for each quarter, so taxpayers will still pay a higher percentage on first and second quarter 2020 balances. The third-quarter ruling isn’t retroactive.
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. The rates are set by the IRS every three months at the federal short-term rate plus 3 percentage points.
The IRS will also pay 3% interest on late refunds, although this rarely happens because the IRS has “administrative time” of about 45 days if you file on or after the due date to process your return and issue a refund.
IRS. "Pay As You Go, So You Won’t Owe: A Guide to Withholding, Estimated Taxes, and Ways to Avoid the Estimated Tax Penalty." Accessed June 12, 2020.
IRS. "When Are Quarterly Estimated Tax Payments Due?" Accessed June 12, 2020.
IRS. "Estimated Taxes." Accessed June 12, 2020.
IRS. "2019 Form 1040-ES Estimated Tax for Individuals," Pages 5-6. Accessed June 12, 2020.
IRS. "IRS Provides Tax Inflation Adjustments for Tax Year 2019." Accessed June 12, 2020.
IRS. "FAQs on the 2020 Form W-4." Accessed June 12, 2020.
IRS. "Form W-4 Employee’s Withholding Certificate." Accessed June 12, 2020.
IRS. "Pay by Check or Money Order." Accessed June 12, 2020.
IRS. "Taxpayer First Act - IRS Modernization." Accessed June 12, 2020.
IRS. "Interest for Individuals." Accessed June 12, 2020.
IRS. "Interest Rates Decrease for the Third Quarter of 2020." Accessed June 12, 2020.