Why Pay Estimated Taxes?
Taxes in the U.S. are on a pay-as-you-go system. When you earn or receive income during the year, you pay federal and state taxes through withholdings and estimated tax payments. Earnings are withheld from sources of income, which include salaries and wages, pensions, and certain government payments such as Social Security. If you receive income that is not subject to withholding such as dividends, interest, gains on the sale of stocks or other assets, alimony, or self-employment income you may be required to make estimated tax payments. Estimated tax payments are paid to the federal and state governments in 4-quarter increments during the year. The federal government due dates are April 15th of the current tax year, June 15th, September 15th. January 15th of the following year. State due dates may differ. Sometimes these due dates fall on a Saturday, Sunday, or legal holidays, the payments are due the next business day. You may make estimated tax payments by mail, over the phone, or online.
IRS Penalty for Underpaying Taxes
Withholdings and estimated tax payments allow taxpayers to avoid the penalty of underpaying their taxes. The typical penalty for underpaying your taxes is 0.5% of the total amount you owe the IRS for each monthly payment that is not received. The four quarterly estimated tax payments must be made on time or a late penalty is added to the underpayment penalty.
You do not have to make estimated tax payments if your income is withheld properly by your employer. This is done through Form W-4. Any income not subject to withholdings may require estimated tax payments to be made. Additionally, you do not have to make estimated tax payments if all below three requirements are met:
1. You have no tax liability for the previous year.
2. You were a U.S. citizen or resident for the entire year.
3. Your previous year’s tax covered a 12-month period.
How to Penalty Proof Yourself
Taxpayers want to penalty proof themselves during the tax year by updating withholdings for changes that may occur in your life (marriage, divorce, children, second jobs, side business, etc.) and by calculating estimated tax payments for income received not subject to withholding.
Estimated tax payments are calculated by determining what is your expected gross income, taxable income, tax, credits, and deductions for the year. Your previous year’s return is a great starting point! Every quarter you would repeat this process especially if you estimated earnings too low. IRS Form 1040-ES is a great tool for individuals including sole proprietors, partners, and S corporation shareholders to help calculate estimated tax payments. However, if you receive income unevenly during the year your estimated tax payment amounts may vary from quarter to quarter. IRS Form 2210 Schedule AI: Annualized Installment Method is a great tool for those who receive income unevenly.
To penalty proof yourself you must meet of one these two requirements for individuals:
1. Pay 90% of the tax you owe in the current year; or
2. Pay 100% of the tax you owed last year.
If your adjusted gross income last year was greater than $150,000 (over $75,000 for married filing separately) you must pay the lower of:
1. 90% of tax for current year; or
2. 110% tax shown on last year’s return.
This is also known as the safe harbor rule.
You will not have to pay an underpayment penalty if one of these apply to you:
1. What you owe the IRS is less than $1,000 in tax after subtracting withholdings, estimated tax payments, and credits; or
2. You had zero tax liability last year, in addition to this exception you must be a US citizen or resident for the entire year.
Also, the penalty may be waived if one of these apply to you:
1. Failure to make estimated tax payments caused by a casualty, disaster, or other unusual circumstances.
2. You retired (after age 62) or become disabled during the tax year or prior year; and the underpayment was due to reasonable cause and not willful neglect.
Questions? Contact an MCB Advisor at 703-218-3600 or click here. You may review our latest news for individual Taxpayers on the IRS website here. To learn more about MCB’s tax practice and our tax experts, click here.
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● “The Basics of Estimated Taxes for Individuals.” Internal Revenue Service: The Basics of Estimated Taxes for Individuals, Internal Revenue Service, www.irs.gov/newsroom/the-basics-of-estimated-taxes-for-individuals.
● “Estimated Taxes.” Small Businesses, Self-Employed, Estimated Taxes, Internal Revenue Service, www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes.
● “Individuals 2.” Internal Revenue Service: Individuals, Internal Revenue Service, www.irs.gov/faqs/estimated-tax/individuals/individuals-2.
● “Pay as You Go, So You Won’t Owe: A Guide to Withholding, Estimated Taxes, and Ways to Avoid the Estimated Tax Penalty.” Internal Revenue Service: Pay as You Go, So You Won’t Owe: A Guide to Withholding, Estimated Taxes, and Ways to Avoid the Estimated Tax Penalty, Internal Revenue Service, www.irs.gov/payments/pay-as-you-go-so-you-wont-owe-a-guide-to-withholding-estimated-taxes-and-ways-to-avoid-the-estimated-tax-penalty.
● Topic No. 306 Penalty for Underpayment of Estimated Tax, Internal Revenue Service, www.irs.gov/taxtopics/tc306.
● “Topic No. 306 Penalty for Underpayment of Estimated Tax.” Internal Revenue Service: Penalty for Underpayment of Estimated Tax, Internal Revenue Service, www.irs.gov/taxtopics/tc306.
Written by: Lina Katemtou