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 enough money during the year to avoid owing a lump sum at filing time – or worse, incurring penalties. Generally, people who have incomes that aren't subject to tax withholding should consider making estimated payments. Types of income without withholding include self-employment income, rental income, investment income and capital gains.
Estimated Tax Deadlines
Estimated tax payments are due quarterly on April 15, June 15, September 15 and January 15. Some taxpayers pay more frequently. You can make payments monthly if you like so a fixed amount of tax is included in your monthly budget. If you have to skip a monthly payment, you can adjust your subsequent estimated payment to cover the shortfall.
The Estimated Tax Penalty
If you don't make estimated payments and end up owing the IRS at the end of the year, a penalty typically applies. The estimated tax penalty is essentially an interest charge for not paying taxes throughout the year. The interest rate for underpayments by individual taxpayers is 4 percent for the 2016 tax year. The IRS sets this rate each quarter.
Figuring Out How Much to Pay in Estimated Taxes
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. 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. If your withholding will be about the same as last year, you can subtract last year's withholding amount. The difference is the amount of tax that needs to be paid in through estimated taxes.
Although this method is quick and easy, it doesn't take changes in your income into consideration or any changes in your deductions for the current year. You might have more or less income or qualify for different tax deductions. The alternate method is to project a tax calculation based on this year's income. For this, it's helpful to use the worksheets found in Publication 505 and with Form 1040-ES.
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 estimated payments.
An Example of an Estimated Tax Calculation
Shelley is an independent contractor and this is her only sole source of income. She had $25,000 of self-employment income and $7,500 of business expenses in the first three months of the year. This resulted in a net profit of $17,500.
Her business isn't seasonal, so it's safe to say that her income and expenses will be similar through the next nine months of the year. The first three months represent 3/12 – or 1/4 – of her annual income. To project her income for the full year, we need to multiply by the inverse or reciprocal ratio. The reciprocal of 3/12 is 12/3, which is the same as saying that the reciprocal of 1/4 is four. Multiplying our year-to-date figures by the reciprocal results in an income amount that is projected to be 100 percent of the full year.
Multiplying Shelley's net profits of $17,500 for the first three months by the reciprocal ratio of 12/3 tells us that Shelley's net profit for the full year will be $70,000.
Now we can begin a tax calculation. Shelley's income will be subject to both the income tax and the self-employment tax because she's an independent contractor. Here's how the tax calculations 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 = 6,100
Personal exemption for herself = 3,900
Taxable income (70,000 - 4,945 - 6,100 - 3,900) = 50,055
Now that we've found Shelley's taxable income, we can calculate her income tax using the 2017 tax rates. As a single person, Shelley's income tax is estimated to be $8,370. This plus her self-employment tax of $9,890.69 equals how much she needs to pay in this year: $18,260.69, or $18,261 after rounding. Shelley would have to pay in at least 90 percent of this amount in order to avoid the estimated tax penalty, but she might also want to pay the full amount of the tax to prevent from owing at tax time.
If she wanted to pay in 90 percent of her current tax due, Shelley would multiply the tax amount by 90 percent then divide by four to find each of her four estimated payments – about $4,109 each. If Shelley wanted to pay 100 percent, she would take the tax amount and divide by four to find each of her four estimated payments of about $4,565 each.
If You Also Have Income That's Subject to Withholding
You can adjust your withholding from your paychecks to cover additional taxes from other income such as interest, dividends, or income from side jobs or consulting work. Simply fill out a new Form W-4 and give it to your employer.
There are a couple different ways you can adjust the withholding figures. One is to change the number of withholding allowances you're currently claiming. The other is to indicate an additional dollar amount that you want your employer to withhold each paycheck.
Let's take the second method first. Let's assume that Nancy will owe $4,000 on self-employment income because she freelances in addition to her regular job. Nancy could take this tax amount and divide it by the number of remaining pay periods in the year. This amount would be entered on Line 6 of Form 1040 as an additional amount to withhold. This additional tax will show up on her W-2 as part of her federal income tax withholding and will be applied to the total tax she owes for the year, including any self-employment tax.
If Nancy wanted to adjust her withholding allowances, she would have to reduce the number of withholding allowances she's currently claiming so that her federal withholding will increase by an amount sufficient to cover the additional tax she's expecting. This often involves trying different withholding allowances using a withholding calculator.
Paying Estimated Taxes
Assuming you can't or don't want to adjust your withholding, you can send in estimated payments by check, pay by credit card, or use the Treasury Department's online bill payment system.
- Paying estimated taxes by check is pretty easy. Just make sure to use the 1040-ES payment vouchers. Make the check payable to the "United States Treasury." In the memo field of the check, be sure to write your Social Security Number and indicate the year for which you are paying, for example, "2014 Form 1040-ES." Avoid making the check payable to the "IRS" or "I.R.S." Some thieves have confiscated these checks and altered the name to "J.R. Smith" or "MRS Smith" or some other permutation. You can prevent this sort of theft by always writing out "United States Treasury" because that can't easily be altered. Mail your check along with a Form 1040-ES voucher to the IRS.
- You'll have to use an authorized third-party payment service to pay by credit card. These payment services process tax payments and forward the funds to the IRS. The payment processing services charge convenience fees, and you'll have to pay any interest or finance charges on top of that. Still, paying by credit card, if you must, can help avoid any late payment penalties charged by the IRS.
- The Treasury Department also operates two online payment systems. One is called the Electronic Federal Tax Payment System, or EFTPS for short. It can take a few weeks to get fully registered with the service, but you can schedule estimated payments from your checking account very quickly once you're set up. EFTPS users can print out a report showing all their estimated payments for the year, which is a handy report to have at tax time. 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.
- The second online payment system offered by the Treasury Department is Direct Pay. Direct Pay is designed to handle payments of personal income tax only. The service does not require registration so you can use Direct Pay straightaway, but you'll have to enter in your information each time you want to make a payment. Both EFTPS and Direct Pay enables people to schedule federal tax payments from a checking or savings account.