What Is Annualized Income?

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DEFINITION

Annualized income generally refers to the calculation of a taxpayer’s income on an annualized basis, rather than just for the period during which the income was earned.

Definition and Examples of Annualized Income

Annualized income often is a calculation of what an individual’s or business’s income would be for the whole year based on a given period. Figuring annualized income can help taxpayers manage their estimated taxes and avoid underpayment penalties.

For example, a taxpayer who earns $25,000 during the first three months of the calendar year could have an annualized income of $100,000. That’s because there are four of these three-month periods throughout the year, so that $25,000 in the first of the four periods essentially means they are on pace for $100,000 over the course of the year, even though the end result might be different.

Annualized income is often used in the context of estimated tax payments.

While many taxpayers have income taxes withheld from their paychecks throughout the year, others, such as freelancers or gig workers who aren’t salaried, might not have any taxes withheld. Instead, these taxpayers typically have to make estimated tax payments on a quarterly basis, rather than waiting until the end of the year to pay taxes.

Yet even employees who have taxes withheld from their paychecks sometimes have to make estimated tax payments to account for large capital gains at certain points in the year, among other reasons.

In many cases, estimated tax payments are made in four equal installments, with one payment made per quarter. However, individuals or businesses with uneven income might not be in the best position to make the same estimated tax payment each quarter.

For instance, a seasonal business like a winter-sporting-goods store might earn most of its income over just a few months of the year. So rather than having to make a large estimated tax payment in the summer when it has very little or perhaps no income, that business could calculate its annualized income and use either what’s known as the annualized income installment method or the adjusted seasonal installment method to make estimated tax payments accordingly.

By using the adjusted seasonal installment method, a business can make a larger estimated tax payment at a time when it has more income to afford the payment, and it can avoid the underpayment penalty that might otherwise be charged if a business doesn’t pay enough taxes on a timely basis throughout the year.

How Annualized Income Works

Annualized income works by calculating what a taxpayer’s income would be over the course of a year based on how much they earned in a given period.

As shown in the earlier example, annualizing the period from Jan. 1 to March 31 would involve multiplying income earned by four, because there are four three-month periods in a given year. Annualizing the period between Jan. 1 and May 31 would involve multiplying the income earned in this period by 2.4.

The full calculations for annualized income, when used as part of the annualized income installment method to calculate estimated taxes and avoid underpayment penalties, can be done via the worksheet on Form 2210 for federal taxes. Taxpayers might also annualize their income for state taxes, which would involve separate forms.

Taxpayers don’t have to annualize their income, but this is an option for those who don’t want to pay estimated taxes in equal installments. Using annualized income could result in paying a lower amount in some quarters and higher amounts in others.

Even with the same total amount due in taxes over the course of the year, this variation could be helpful to businesses and individuals with inconsistent earnings, as it may reflect the fluctuations in cash available to them to pay taxes through the year.

Key Takeaways

  • Annualized income results from figuring out what the income in a given period would equate to if the same pace continued for the full year.
  • Calculating annualized income as part of the annualized income installment method can be used to avoid underpayment penalties for estimated taxes.
  • Taxpayers with seasonal income or unexpected gains during the year could benefit from annualizing their income.

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