Regular employees automatically have their taxes withheld from their paychecks and paid to the IRS by their employer. However, self-employed individuals and business owners must estimate how much tax they owe and pay to the IRS.
Estimated tax payments are made quarterly by people whose income isn’t subject to withholding taxes such as dividends, interest, or rent. In this article, we will look deeper into estimated tax payments and how to determine what you owe.
Defining Estimated Tax Payments
The IRS estimates your tax liability for the year by looking at what you owed in the previous year. According to the tax code, you need to make estimated tax payments if you’re self-employed and expect to incur a $1,000 tax liability for the year, or if your earnings come from owning a corporation or a partnership and expect your tax liability to be more than $500.
Individuals and corporations are required to make regular estimated tax payments on all taxable income they earn. The IRS also assesses a penalty for those who underpay taxes.
When hired, regular employees accomplish a W-4 tax form, so employers know how much to withhold from their wages as tax. The withholding amount gets automatically deducted from the employees’ paycheck and periodically paid by the employer to the IRS as an estimated tax payment. When employees file a tax return, they’ll know whether the amount withheld was enough to satisfy the actual tax liability or whether it was too much, and they are eligible for a tax refund.
The same goes for self-employed individuals whose taxes are not regularly withheld. They make an estimate from the previous year’s income every quarter and submit payments based on these to the IRS. Similar to regular employees, the annual tax return will show if the estimated tax payments were too high or too low.
Figuring Out What You Owe
It’s essential to come up with a reasonable estimate of your income and deductions to report on your federal tax return.
There are different software applications that you can use to do the computations for you or get a copy of the worksheet that goes with Form 1040-ES so you can work your way through it.
Regardless of the method you choose, you’ll need these items so you can plan what your estimated tax payments should be:
- The federal tax return in the previous year. You can check using your previous year’s federal tax return to ensure that all your expected income and deductions are included on your current year’s tax return. Also, look at the total tax you paid if you will base your estimated tax payments on 100 or 110 percent of your taxes in the previous year.
- A record of all estimated tax payments you’ve already made for the current year. You need to consider those payments when you determine how much tax you still owe. Look up all the amounts you paid for the current year and the dates.
Pay with Your Tax Refund
An easy way to minimize your taxes is to apply your tax refund from the previous year to your next year’s taxes. Having all or part of your tax refund applied to your estimated taxes allows you to take care of at least a part of what you owe for the following year. If you weren’t able to pay enough income taxes through withholding or estimated tax payments during filing time, you could end up owing the IRS an underpayment penalty on top of the taxes you owe.
The amount of penalty will depend on the total amount you owe and how long you’ve owed it to the IRS. In short, you will have to pay a larger amount to the IRS when you file your return due to the underpayment penalty.
Do I Need to Make Estimated Tax Payments?
Remember: you would need to make estimated tax payments every quarter if you won’t have federal income tax to be withheld or you have other income, and your withholding tax will not be sufficient to cover your tax liabilities.
To determine if you need to pay estimated taxes every quarter, answer the following questions:
- Do you expect to owe less than $1,000 in taxes for the year after subtracting your federal income tax withholding from the total amount of your tax burden? If yes, you don’t need to make estimated tax payments.
- Do you expect your federal income tax withholding and any estimated taxes you paid on time to be at least 90% of the total tax that you’ll owe for the year? If yes, you don’t need to make estimated tax payments.
- Do you expect your income tax withholding to be 100% of the total tax on your previous year’s return? Or if your adjusted gross income on your tax return exceeds $150,000 (or $75,000 if you’re married and file taxes separately), do you expect that your income tax withholding will be at least 110% of the total tax you owed for the previous year? If yes, you don’t need to make estimated tax payments.
If your answer is no, you need to make estimated tax payments using Form 1040-ES. Want to know more about estimated tax payments? You may also want to consult with the tax experts at Lear & Pannepacker, LLP if you want to address your tax concerns.