Posted by Jim McClaflin, EA, NTPI Fellow

A Guide To Tax Estimation: What is it & When to Pay It

A Guide To Tax Estimation: What is it & When to Pay It

Those who cannot withhold federal taxes from each paycheck must pay taxes quarterly.

United States income tax operates on a pay-as-you-go system, in which the federal government collects income taxes throughout the year through payroll taxes. Ideally, you have already paid all taxes by the time you file your tax return before the April deadline. Most people pay extra during the year, so they get a tax refund from the IRS. If you pay less, you will have to pay an invoice in return.

However, not everyone has an employer with withholding tax. Small business owners, the self-employed, and workers who receive Form 1099 instead of a W-2 must pay taxes throughout the year. They do this with estimated quarterly tax payments.

The process for paying estimated taxes is to calculate how much tax you will have to pay during the year (also known as tax liability), divide that number by four to find the quarterly tax payments, then make the payments on time. If your income changes during the year or your estimated income changes, you may need to recalculate each quarter. When tax season arrives, you still need to file a regular tax return.


Who Pays Estimated Taxes

You will likely have to pay the estimated taxes if you are claiming as a self-employed person, sole proprietor, partnership, or shareholder of an S corporation. Additionally, self-employed persons, contractors, and others whose income is reported on 1099 instead of a W -2 must pay the estimated taxes.

Specifically, you must make estimated tax payments if you intend to pay $1,000 or more when filing your annual tax return. The same goes for businesses that expect to owe at least $500.

If you don't know if you owe that much, you need to calculate your tax liability to be sure. Failure to pay estimated fees when you need them may result in penalties.


Who does not have to pay estimated taxes?

If all of your income is reported on a W-2, you won't need to estimate the tax payments—employers who issue a W-2 withholding tax to you throughout the year.

Employees whose income is tax-exempt outside of work can also avoid estimated taxes by withholding more wages than the employer. You just have to do more tasks on the W-4 form. However, it may be safer for you to pay your taxes directly and with estimated taxes.

Taxpayers who receive alimony or an annuity can use Form W-4P to change the withholding tax on these payments. Certain government payments are also eligible for voluntary withholding tax via Form W-4V.

Plus, you don't need to pay an estimated tax if you meet all of the following criteria:

  • The last tax return covered a full calendar year (12 months)

  • You have had no tax debt during the past year

  • You were a US citizen that entire year.


Calculating your estimated costs

For assistance in calculating estimated payments, individuals can use the IRS Estimated Spreadsheet found in the Instructions for Form 1040-ES. Businesses can find instructions on Form 1120-W.


Start with Income Tax.

The basic process of determining tax liability begins with Adjusted Gross Income (AGI). If you expect this year's income to be similar to last year's income, you can use the AGI from last year's tax return as a starting point.

Decrease the standard deduction or the amount of itemized deductions from adjusted gross income. The figure you have after taking these deductions is your taxable income.

Once your taxable income is known, use the federal income tax intervals to find out how much you owe.


Add self-employment tax

Regular employees receive money withheld from wages to fund Social Security and Medicare. This is in addition to the payment of income tax. Self-employed workers, including entrepreneurs and self-employed workers, do not have this withholding tax and therefore pay a self-employment tax to ensure their participation in these programs.

When calculating estimated taxes, self-employment tax should also be calculated if the net income from self-employment is at least $400 for the year.

To calculate self-employment tax, take total income and multiply it by 92.35% because the federal government only collects tax on 92.35% of income. The result is essentially the self-employment tax base.

Then you can apply the actual tax, which is 15.3% (12.4% for social security tax and 2.9% for health insurance tax).

Add the self-employment tax to your income tax, and you have all the tax debts. Divide the total by four and get the estimated quarterly tax. It's common for people to pay four equal amounts, but you'll need to calculate your debts quarterly if your income is irregular throughout the year.


Other types of income to consider

In some cases, you may have other sources of income. As with the self-employment tax, you must include it in your estimated tax payments.

For example, you may have to pay capital gains tax if you sell a house or stocks at a high profit. You can also get a big cash win, for example, by paying a lump sum of 401(k).

However, please note that not all income is subject to income tax. Examples of tax-free income include Social Security payments, workers 'benefits, child support, certain veterans' benefits, gifts, inheritance, and life insurance in the event of death.

As mentioned above, employees who receive a W-2 can also adjust their own withholding taxes (on W-4 forms) to avoid estimated taxes. This is useful if you receive a single cash receipt, such as a will. The key is to ensure you cover at least 90% of your tax obligations to avoid fines and a tax day.


How are the estimated taxes paid?

People who file estimated taxes should complete Form 1040-ES. Businesses must submit Form 1120-W.

The easiest way to pay taxes is via electronic means. IRS Direct Payment lets you to make payments directly to Uncle Sam. You can transfer money directly from a bank account and pay by credit or debit card. The IRS mobile application, IRS2Go, enables electronic payments.


You can also pay the estimated fee by phone, wire transfer, check, order for payment, or cash through one of the IRS's business partners. If you are paying in cash, you are limited to one transfer of $1,000 per day and must be pre-registered online with the IRS.

When sending a payment by mail, be sure to include proof of payment on Form 1040-ES. The voucher is just a piece of paper with your personal information, so the IRS knows who is making the payment.

It is best for businesses and those with high payments to use the Electronic Federal Tax Payment System (EFTPS). EFTPS is a free tax service provided by the US Department of the Treasury. You need to sign up for the program, which lasts a few days, so be sure to do so.


Paying Joint Estimated Taxes

In some cases, a couple owes the estimated costs together. For example, you can realize capital gains by selling a house that each of you owns half of. If you intend to file a joint return during tax time, you can also pay the estimated taxes together. Send a single payment slip with your name and social security numbers in the same order you entered them on your tax return.

You don't need to pay together if you intend to submit separate returns during tax time. You also cannot pay together if you are divorced, if you or your spouse is a non-resident alien, or if you and your spouse have different tax years (your statements cover different 12-month periods).

In community-owned states, the property belongs to the spouses, and any capital gains that result in estimated taxes are likely to be shared between you two. If you are unsure of the ownership of your property, we recommend that you consult a lawyer.

Please note that you cannot make estimated tax payments together by state law if you are in a registered partnership, civil partnership, or other formal relationship other than marriage.


Can you make more than four payments?

Yes! You can make several payments and send them out at any time during the quarter. Additional payments are required if you paid less for a quarter and more to make up the difference. This can happen if you earn more in a quarter than expected.

No matter how many payments you make, you must pay the correct amount by the quarterly due date. If you pay less, the IRS will charge you a penalty.

Penalties for non-payment of taxes

If you don't pay enough or miss a due date, you will have to pay the penalty to the IRS. The amount of the fine is dependent on the late payment and how much you paid less.

There are several ways to avoid paying fines:

  • Always pay at least 90% of your tax debt

  • Pay 100% of last year's debt 

To avoid a fine, the rule of thumb is that you must pay at least 90% of your tax debt per quarter or year. As long as you do this, you will never incur a penalty for non-payment.

There is one important exception to this rule. Farmers and fishermen earning at least two-thirds of their gross income from farming or fishing should only cover 662/3% of their tax obligations.

The safest way to avoid penalties is to pay off 100% of the previous year's tax debt. This is sometimes referred to as the Safe Harbor Rule.

However, there are a few exceptions to this rule. If your adjusted gross income was at least $150,000 last year (or $75,000 if your marital status for the upcoming year is married filing separately), then you have to pay 110% of debt from last year to meet the Safe Harbor Rule. This rule also does not apply to farmers or fishermen.


Estimated State Taxes

All of the above information relates to federal income tax. If your state or city also collects income taxes, you will likely pay estimated state taxes. In many cases, the procedure and time frames are the same as listed above, except that payments are made to the state or local county. For more information on local rules, talk to a tax professional.


Summary

  • Estimated taxes are charged for self-employed, sole proprietors, partnerships, and S shareholders.

  • You must make quarterly tax payments to cover your tax obligations for the year.

  • Always cover at least 90% of your liability to avoid penalties.

FOR MORE INFORMATION ON HOW JIM McCLAFLIN, EA, NTPI FELLOW CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.



Jim McClaflin, EA, NTPI Fellow
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