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What are Estimated Tax Payments?


This time of year I often find myself explaining to clients what estimated tax payments are, why you need to make them and how they are calculated. Here's a quick primer on estimated taxes for you.

First, let's cover who needs to make estimated payments and why. If you hold a regular salaried job, then your employer most likely withholds taxes from each paycheck. If that's your only income, then you don't need to pay estimated taxes - your withholdings should cover your tax payment requirements.

However, if you also have other income sources, such as investment income from interest and dividends or rental income or retirement plan distributions, you also need to pay taxes on that income. And if you are self-employed or an independent contractor who has no taxes withheld from your pay you will definitely need to pay estimated taxes. The easy way to think about it is to look at all the taxable income you have for the year - if you had taxes withheld on that income, then you don't need to pay estimates, but if you didn't then the IRS is going to want some money from you!

The IRS requires you to pay in at least 90% of your current year tax liability OR 100% of your prior year tax liability (110% if your adjusted gross income exceeds $150,000). Each state has a different set of rules but most are similar to the IRS. If you don't meet these minimum payment requirements, called a "safe harbor", then you could be subject to underpayment penalties that are calculated based on how underpaid you were throughout the year. 

If your income varies significantly from year to year, this can make calculating estimated tax payments fairly difficult. The easiest method for paying estimates is to just pay 100% (or 110%) of your prior year tax. This way you are guaranteed to not face any underpayment penalties and the calculation is simple. Unfortunately, it also means you could have way too much paid in if your income is much lower in one year compared to the prior year. It could also leave you with not enough paid in if your income is much higher than last year. In that case, the extra would be due in April but would not be subject to penalties.

So what do you do if you don't want to pay too much in estimates? First you need to make some assumptions about what your current year income and expenses will look like. If it's as simple as one big transaction from last year that won't happen again, we can make that adjustment easily. If there are bigger changes to the numbers it usually makes more sense to run a detailed tax projection to try to estimate what your tax liability will be for the current year.

Estimated tax payments are due quarterly - April 15th, June 15th, September 15th and January 15th. Many of our clients like to have us look at their tax situation on a quarterly basis to make sure each payment is in line with their actual income and expenses to date. This is the best possible way to make sure your estimates stay on track if you have variable income.

Regardless of which method you choose, we are here to help you determine what you should pay and when you should pay it. If you have any questions feel free to contact us.