The IRS says that if you’re not withholding enough taxes throughout the year you have to pay an underpayment penalty. This can even be true if at the end of the year you’re due a refund! Much of the time this isn’t a problem, especially for people who earn a majority of their income through wages working a W-2 job. Usually the withholding for federal taxes are enough and you can check that each time you get a paystub.
But if you are going to owe at least $1,000 in federal income taxes this year (after withholding and refundable credits) AND your withholding and credits cover less than 90% of your tax liability for the current year or 100% of your liability for the last year (whichever is less) then you’ve got to pay estimated taxes.
Estimated taxes are due each quarter but you can pay them weekly or monthly or however like, just as long as the IRS receives the quarterly estimate by the deadline for that quarter.
Who Needs To Pay Quarterly Estimates?
Anyone that isn’t going to satisfy the above criteria through regular withholding! This means self-employed people that take a draw or profits, partners in business that receive payouts, side-hustlers that pocket extra cash, farmers1 (if less than 2/3 of their gross income comes from farming), house-flippers, and more.
People with non-qualified investment accounts should be wary too. Dividends and interest shouldn’t be a concern, but if there is any income realized from the investments then that could result in a surprise underpayment penalty and trigger estimated tax payments (this is yet another reason that realizing short-term capital gains in an investment account is a really bad idea). The same is true for anyone receiving rental income!
How To Pay Quarterly Estimates
It’s easiest and simplest, after estimating your taxes owed for the upcoming year, to pay electronically. Yo can do that on the IRS website here: https://www.irs.gov/payments. This eliminates some of the risk of the IRS depositing your tax check and not crediting you for it! Always keep good records. I’ve heard stories of the IRS depositing estimated tax checks and not crediting it to your account and then you have to track down which payment is the one they missed and it can be quite a hassle. It’s a good idea if you are sending a paper check through the mail to send identify each deposit with the quarter you’re paying.
EXAMPLE: You calculated that you need to pay estimated taxes of $1,000 a quarter. The first quarterly check is due in April so you send $1,001. The next quarter is due in June and you send $1,002. In September you send $1,003. In January you send $1,004.
Avoiding Estimated Taxes (and penalties!)
If you have income that is subject to withholding you can update the withholding to cover your total tax liability for the year. This is the simplest and easiest solution for avoiding paying estimated taxes AND avoiding any underpayment penalties that could arise. Using form W-4 you can update your withholdings through your employer or payroll processor to send enough federal tax payments to the IRS to satisfy the rules. Form W-4 is available on the IRS website: https://www.irs.gov/forms-pubs/about-form-w-4.
EXAMPLE: John works as a manager at a company making $100,000 a year gross wages. John also farms on the side and has net profits of $10,000 this year. Since his farming income is less than 2/3 of his gross income it could trigger quarterly taxes due as he earns that income. To avoid that possibility and avoid an underpayment penalty John updates his withholding at his manager job to withhold taxes that reflect a total income of $110,000 instead of $100,000.
Other ways to avoid estimated taxes are to increase your deductions, expenses, or refundable credits. You can defer income into retirement plan vehicles like IRAs, 401(k)s, and more. These are especially good retirement planning and tax planning strategies at the same time. A financial planner teamed up with an awesome tax preparer can be a dynamic duo for tax strategy and savings.
Find A Great Tax Pro
Estimating your taxes due for a year that hasn’t happened is equal parts art and science. It’s very important to work with an awesome and qualified CPA or tax professional that can help figure this out with you.