If you earn income that doesn’t have taxes automatically withheld, such as income from investments or self-employment, you may need to pay estimated taxes. Estimated taxes are pay-as-you-go tax payments individuals make throughout the year, typically quarterly, to cover their expected tax liability. The quarterly payment approach can help avoid underpayment penalties. However, instead of paying quarterly, you can also pay estimated taxes when you file your return, increase tax withholding from another source of income, or apply your refund to any balance due. Consider asking a financial advisor to walk through the process and help avoid penalties.
Estimated Tax Basics
You generally need to pay estimated taxes if you expect to owe at least $1,000 when you file your tax return. This includes income earned from self-employment, freelancing, side jobs, interest, dividends and capital gains. The IRS requires you to pay as you earn to ensure the government receives a steady stream of tax revenue, rather than getting a lump sum payment once a year.
It’s usually in your best interest to go along with this requirement. That’s because, if you don’t pay enough estimated taxes during the year, you may owe an underpayment penalty when you file your return. The IRS calculates underpayment penalties by charging interest on the amount underpaid. The interest rate it charges changes periodically, with the rate currently set at 8% annually.
Different Ways to Pay
While you have to pay, you have a few options for the way you make estimated tax payments:
- Pay quarterly: Most taxpayers do this, sending in quarterly installments on April 15, June 15, September 15, and January 15. Each installment generally is equal to one-quarter of the total tax bill you expect. You can pay online, by phone, or by mail using Form 1040-ES.
- Pay when filing: Instead of quarterly payments, you can pay your full estimated tax liability when you file your return by the April deadline. This increases your risk of penalties if you underpay, however.
- Withhold from other income: If you have W-2 job income, you can increase your withholdings to cover estimated taxes on 1099 income.
- Apply refund to balance: If you’re owed a refund, you can apply it to estimated taxes due instead of receiving a check.
Avoiding Underpayment Penalties
You can sidestep underpayment penalties even if you haven’t paid enough in estimated taxes to equal your total current tax bill. Do this by meeting one of the IRS safe harbor rules. For most taxpayers, this means paying estimated taxes equal to at least 90% of your current year tax liability or 100% of your prior year liability.
That is, if you owed $9,000 last year and have paid in $9,000 in estimated taxes for this year, you have met the safe harbor provision and won’t be subject to underpayment penalties, even if you owe more in taxes this year. You would also satisfy the safe harbor provisions if you paid $9,000 in estimated taxes this year and your current tax liability is no more than $10,000, since $9,000 is equal to 90% of $10,000.
Higher-income taxpayers have a different standard. If adjusted gross income (AGI) exceeds $150,000, they must pay at least 110% of their prior year liability.
An Estimated Tax Example
Consider a self-employed taxpayer who expects to earn $60,000 this year. They had no tax liability last year. To avoid underpayment penalties, they must pay at least 90% of their expected 2023 tax liability.
They calculate this will be about $13,500 based on their income and deductions. To meet the safe harbor, they must pay at least $12,150 during the year. That amount is equal to 90% of $13,500, which fulfills the IRS safe harbor provisions. They decide to pay quarterly installments of $3,037.50 each.
This helps avoid a penalty while providing a framework for budgeting tax payments over the year. If they owe any additional amount when filing their return, they can pay it by April 15.
Paying estimated taxes is required for anybody who earns income from self-employment or another source that does not withhold taxes. Making quarterly payments of enough to meet the IRS safe harbor provisions helps avoid penalties. It also allows you to budget tax payments each year so you don’t face a big payment at filing time. However, you can wait to pay estimated taxes until you file your return if you are willing to pay the underpayment penalty. Other options include withholding more from another income source or allocating part of your refund to estimated taxes.
Tax Planning Tips
- Connect with a financial advisor who can analyze your situation and suggest a tax planning strategy. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s income tax calculator to figure out how much estimated tax to pay.
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