Executive Summary
- The IRS expects taxes to be paid throughout the year, either as payroll withholding or as estimated payments.
- Estimated payments are due April 15, June 15, September 15, and January 15.
- Penalties are imposed by the IRS if taxes are underpaid, but depending on the tax due, the penalties may not be life-changing.
Hopefully, you have put your 2018 taxes to bed and are ready to focus on 2019. If you were hit with a payment surprise on this year’s individual tax return, you may have promised yourself to pay more attention to your estimated taxes this year.
Don’t stress. They are called “estimated” taxes.
What are estimated taxes?
It’s not just what you owe the IRS, but also when you owe it. Estimated tax is the method used to pay tax on income that is not subject to withholding. It’s the difference between having an employer withhold the taxes for you each payday or you having to make a federal tax deposit each quarter. For purposes of this discussion, I am referring to individual estimated taxes, not corporate estimated taxes. Individual estimated taxes are required on income from a business that passes through to the individual level which would include the following entities: sole proprietorships, S-corporations, partnerships, and limited liability companies.
Why does the IRS require estimated payments?
The IRS likes to receive their money throughout the year and will penalize you if you wait until the due date of your return to pay the tax you owe. Thus, if you are receiving wages, your employer is required to withhold a portion of your salary each paycheck as tax withholding (based on the W-4 form you filled out for them). If you are earning your income from a non-salary source, you are expected to pay estimated taxes each quarter.
Do I have to pay estimated taxes?
If you have a small business, usually. It depends on how much tax you are going to owe and whether you are willing to pay the penalty. There are two reasons you would not have to pay estimated tax:
- You had no tax liability for the previous year. Note I said no tax liability, meaning you owed the government no tax. Don’t confuse this with showing no tax due on your return, or
- Your tax liability minus withholding is less than $1,000 when you file your return.
If you are employed and don’t have significant additional income from other sources, you usually don’t need to worry about estimated taxes. Just make sure the W-4 form you file with your employer is withholding enough to cover your tax liability.
Another caveat about estimated taxes. If you are married, filing jointly, the IRS does not distinguish between your and your spouse’s liability. That means that all the limits and exceptions listed here apply to what will appear on your joint return, not just your business portion of the return.
Also, don’t forget if you have a state income tax, your state most likely has an estimated tax requirement as well.
When do I have to pay them?
Estimated taxes are to be paid 15 days after the end of each quarter (three month period). For individual taxpayers, the due dates for estimated taxes are April 15, June 15, September 15, and January 15.
How much do I need to pay?
To avoid a penalty, your estimated taxes must equal the lesser of:
- 100% of the prior year’s tax liability (110% if your Adjusted Gross Income is greater then $150,000), and
- 90% of this year’s tax liability. (80% for 2018 ONLY.)
You may hear your tax adviser throw out the term “safe harbor”, which is just fancy talk for that prior year 100% exception. The “safe harbor” rule is great if you are expecting to have a larger tax liability this year because it can prevent you from having to pay your taxes as early. However, if your income will be lower this year, using the “safe harbor” rule will just cost your cash that you could use elsewhere.
How do I pay them?
You can set up an account with the Electronic Federal Tax Payment System (www.eftps.gov) and pay them online. Just realize it takes a little time to get it setup, as the IRS will mail you some login information.
You may also write a check and mail in with the 1040-ES voucher. Your payment must be postmarked by the due date and you are taking a risk that your payment won’t be received.
You can use third-party payment providers that will allow you to make credit card payments to the IRS. Just watch their fees– debit cards are usually a flat charge ($3-4), but credit cards are a percentage of tax payment (1-2%).
What if I don’t pay?
If you don’t pay estimated taxes, you will be assessed a penalty for the amount of money you didn’t pay and for how long it was not paid. It is roughly the equivalent of paying interest on the money that you “borrowed” from the IRS. For 2018, for example, the penalty was 4 percent annually. After you file your return, the IRS will compute the penalty and send you a bill.
An Action Plan
Estimated taxes cause business owners a lot of stress. Not only are you having to come up with cash each quarter, but you are also having to estimate your tax liability. That means you need to have a pretty good handle on your projected business income, as well as your spouse’s contribution to income and withholding. Here are some things to keep in mind when approaching estimated taxes.
Use a tool such as TaxCaster by Turbo Tax which will give you a rough estimate of your tax liability based on some basic items. Use your last year’s tax return as a starting point, adjusting for changes to this year’s business income.
If you have a working spouse and you can make a pretty good estimate of your business income, you might find it easier to increase your spouse’s withholding to compensate. Your spouse can file a new W-4 form with his or her employer indicating the additional withholding desired on Line 6.
Another tax planning strategy also involves your wage-earning spouse. If you are coming up on the end of the year and realize that you did not pay enough estimated taxes, you can adjust your spouse’s withholding for the last several paychecks of the year. The IRS assumes that withholdings are paid continually throughout the year as opposed to estimated taxes, for which underpayment is computed based on the actual date paid.
If you had a wage-earning job last year and started a business this year, you will most likely NOT want to use the “safe harbor” rule (the 100% of last year’s tax liability). I am assuming that your new business will earn less than your wage-earning job, so you don’t want to tie up your cash with the IRS. At the end of each quarter, compute your income and multiply by the tax rate from your last year’s tax return. Make your estimated tax payment based on this computation, recognizing that it might be slightly high since if your income drops, your marginal tax rate may drop as well.
Remember that you can’t get any estimated tax payments back if you overpay until you file your tax return. So if you are anticipating a loss in future quarters, adjust your current estimated tax payment accordingly. The last thing you want to do is give the IRS money that you ultimately won’t owe and that you will need in the future for your business.
If cash is tight and you are having to borrow to make your estimated tax payments, you might consider not making them and just paying your taxes at year-end when your return is due. The underpayment might be cheaper than an expensive credit card loan. Just remember that you must pay all taxes due on April 15 or you will be subject to a failure to pay penalty, which can be expensive (0.5% a month for each month or partial month the taxes are unpaid, up to 25%) . Filing an extension of time to file your tax return does NOT extend the time for payment.
Most tax preparers will give you a nice schedule of quarterly tax payments to make based on last year’s tax return. Just be aware that it is unlikely that this year will match last year. You need to monitor your business income and adjust the tax payments accordingly to make sure you don’t give away all your cash or end up with a big surprise at year-end.
Finally, don’t stress. Remember that they are called estimated taxes. You won’t ever get them “spot-on”– just aim for close. Besides, you don’t want to spend more money improving the estimate than you would pay in penalties.
More detailed information can be found on the IRS website:
Publication 505 Estimated Taxes Publication
Form 1040-ES Form for sending in estimated tax payments
Form 2210 Form for computing underpayment penalty
Form 2210 Instructions for computing underpayment penalty
