You know what they say about death and taxes. If you work for an employer, the IRS requires the employer to withhold taxes. You have to pay taxes on your own if you don’t have an employer. You can’t just wait to pay when you file your tax return. The IRS describes it this way in Topic No. 306 – Penalty for Underpayment of Estimated Tax:
“The United States income tax system is a pay-as-you-go tax system, which means that you must pay income tax as you earn or receive your income during the year. You can do this either through withholding or by making estimated tax payments. If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.”
Based On Last Year or This Year
To avoid an underpayment penalty, the IRS says you must pay this much, whichever is lower:
- 100% of the total tax last year (110% if your last year’s AGI is more than $150k); or
- 90% of your total tax this year
Between the two methods, it’s simpler to use the total tax last year because it’s not a moving target. After you file your tax return, you already know what that number is. Then you just take 100% or 110% of that amount as your target this year. It doesn’t require guessing your income or estimating your taxes this year.
Use Withholding
The best way to cover your taxes is to use withholding. This is because taxes paid through withholding are assumed to be paid evenly throughout the year even if the actual withholding is more skewed toward the end of the year.
I had worked as both a W-2 employee and self-employed for a long time. I just had my employer withhold extra to cover the taxes owed on my self-employment income. I know how much I need to withhold based on my total tax last year. I then requested my employer to withhold extra from my paychecks to hit that target.
You can also withhold taxes from other income sources if you don’t have an employer. If you’re on Social Security, you can withhold up to 22% for taxes. If you have a pension, you can ask the employer to withhold taxes. If you withdraw from your pre-tax 401k or IRA, you can withhold taxes from those withdrawals.
You won’t owe an underpayment penalty when your total withholding covers 100% of your total tax last year (110% of your total tax last year if your last year’s AGI is more than $150k).
Estimated Taxes
If you don’t have a source of income from which to withhold enough taxes, you should pay the difference as estimated taxes to the IRS on your own.
The IRS expects estimated tax payments in four equal installments by April 15, June 15, September 15, and January 15 (of the following year). The due dates are extended to the following business day if they fall on a weekend or holiday.
If you’re using the prior-year method, it’s as simple as dividing your target number by four and scheduling the payments before those dates.
If you’re more into unnecessarily complicating things, you can estimate your taxes as you receive income in the current year. The IRS receives copies of 1099 forms after the end of a year from places that pay you but they don’t know when you were paid during the year. Even if you earn 100% of your income in January, you can still pay in four equal installments.
If you earn more of your income in December, the IRS doesn’t know that. You can file a Form 2210 to show that you paid less early in the year because your income skewed more toward later in the year. That’s more work though. It’s much easier to cover your taxes through withholding or make four equal payments based on your total tax last year.
State Income Tax
States want their taxes too. I live in California, which has the same due dates as the IRS, but it has an accelerated collection requirement. Instead of 1/4 by each due date, California requires 30% of the annual tax due on April 15, another 40% on June 15, no payment on September 15, and a final 30% on January 15 of the following year. California gets paid more sooner this way. By June 15, California will have already received 70% of the annual estimated tax.
Paying Online
The tax authorities make it relatively easy for you to pay your taxes. The IRS offers Direct Pay for making up to two payments at a time. No login or password is required. You just pay with a bank account. For scheduling up to four payments, the IRS offers EFTPS, which requires registration and waiting for a PIN coming by mail. If you’d like to earn some reward points you can also pay with a debit card or a credit card through some third-party processors. The third-party processor will charge a fee but the fee may be lower than the value of the rewards you earn.
California’s Franchise Tax Board offers Web Pay, which you can use either with a registered account or without. Without a registered account, you can just pay on the fly. With a registered account, you can link a bank account and schedule payments ahead of time. Most other states have a similar arrangement to accept tax payments.
Because I will be paying on my own in the foreseeable future, I registered for both IRS EFTPS and California’s Web Pay. The scheduled payments for April 15 went through smoothly.
I noticed that if you schedule a payment, the date specified is the date the debit will hit your account. They send out the debit the night before to make the debit hit your account on the scheduled date. So make sure you have the money in the account on the scheduled date and don’t think you have another day after the scheduled date. If you don’t have enough money in your account when the debit hits, the IRS can charge you a dishonored payment penalty of 2% of the payment amount with no cap. California also charges a similar dishonored payment penalty. Bouncing those debits can cost a small fortune!
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DB says
This is helpful, thank you. You mention IRS expects equal installments and then go on to say the amount can be adjusted later in the year if you earn more income? So, in other words, you do not have to four pay equal installments, correct?
If one leaves their job at the beginning of the year and their employer withholds taxes for the first quarter, does one pay estimated taxes for the remaining three quarters of self employment income by estimating the remaining tax owed for the year (after accounting for employer withholding from first quarter)?
Thanks.
Harry Sit says
First of all, using prior year’s tax gets you out of the guessing game. If your previous year’s tax was $20,000 and your AGI was under $150k, you just take $20k divided by 4 and pay $5,000 each by the due dates (add 10% if your previous year’s AGI was over $150k). That works no matter what your current year’s income will be.
If you expect your tax this year will be substantially lower than the previous year and you are up to the guessing game, you then estimate your annual income and project your tax as you go along. Suppose you earned $25k from January through March, that’s an annual rate of $100k. You project what your tax will be with $100k income and your deductions and credits. Whatever number that is, divide by 4 and pay by April 15. If come November you have a good month and you make $80k in that one month alone, you then update your annual estimate, recalculate, and pay up on the next due date.
If you have withholding, yes, take that into account when you pay estimated taxes. When I left my employer last year, I had the employer withhold extra to cover my expected self-employment income for the rest of the year. Then I didn’t have to pay estimated taxes myself.
The guessing game is not fun. Avoid it if you can.
Bruce Wilson says
Hi Harry,
I am in similar boat. My spouse just retired, and based on an earlier comment from you I read, we are doing quarterly payments based on LY total tax. Makes sense on the known number.
I will likely pay too much, but we have been doing Roth conversions toward the end of year if it doesn’t throw us into other tax gotcha’s. So we are basically paying tax now in case we make a conversion. Seems a little weird, but worse case we don’t make a conversion and get a big tax refund. The personal toolbox program you referenced is a big help in evaluating Roth conversion piece.
Thanks for all you do to educate!
Bruce
Harry Sit says
If you don’t make a Roth conversion this year, you will pay too much this year and get it back as a refund. The bright side is your next year’s estimated tax will be based on the low tax number this year.
FinancialDave says
I didn’t see it mentioned but also if you owe less than $1000 you are fine as well.
Harry Sit says
The $1,000 threshold becomes helpful when your current year’s tax turns out to be under $10k but you can only use it when you pay through withholding. For example if your current year’s tax is $8,000, you are good if you have at least $7,000 through withholding. However, if you pay taxes on your own, not through withholding, you still must pay at least $7,200 (90% of $8,000). If your current year’s tax is greater than $10k, the 90% rule gives you a larger leeway.
FinancialDave says
Harry,
In general, there are many nuances to the 2210 underpayment penalty form, but you are correct in as much as estimated payments aren’t part of the calculation for the $1000 threshold.
To be fair, in 50 years of paying taxes I have never made any estimated payments as it always seemed like a waste of time and energy when there are other withholding methods available. Now in retirement one of my favorites is a late December IRA withdrawal/withholding.
However, please note in 2018 you only needed to be within 80% of your target tax for 2018 and not 90%.
Also, I can find no reference to the $10k limit you suggest for current year tax in order to use the $1000 figure. At least on the IRS 2210 flowsheet or calculations. Reference lines 1-7 on 2210 underpayment form, for the calculation of when the $1000 target applies.
Also, See part II of 2210 to see when estimated taxes DO apply and that they only need to get you to 80% of your amount due.
Dave
Harry Sit says
10% of $10k is $1,000. That’s why. If your tax this year will be $15k, you are allowed to be short by $1,500, and you can pay through either withholding or estimated tax, or a combination. In that case being short only by $1,000 and only through withholding is moot.
I don’t have anyone doing withholding for me. I will have to pay estimated taxes myself. That’s why I signed up with IRS EFTPS and California FTB Web Pay.
FinancialDave says
Harry,
I think we may be talking about different tax years. I was specifically talking about 2018 as I stated above. Not sure if it will apply in 2019:
https://www.journalofaccountancy.com/news/2019/mar/irs-relief-from-underpayment-penalty-201920862.html
If your example was for 2018, then if the tax due was $15,000, you only needed withholding and estimated payments = to $12,000.
Harry Sit says
I was responding to your comment “I can find no reference to the $10k limit you suggest for current year tax in order to use the $1000 figure.” The $10k limit is derived from the 90% rule.
2018 is already behind us. They lowered the 90% minimum to 80% because many were surprised by the changes in withholding tables. It was a one-time deal. Whatever you had in withholding or paid in estimated tax for 2018 can’t be changed now. Either you made the cut or you didn’t. We can only make decisions on how much to withhold and/or pay in estimated taxes for 2019 and beyond.
Mapleton Reader says
In 2019 I worked for three months, then retired, then began made a large withdrawal from my IRA late in the year for which I paid quarterly taxes for the first time (December). H&R Block tax software noted that I probably owed a penalty for underpayment even though my total taxes paid (withholding + my single quarterly payment) was greater that what I owed. To clean this up I had to file Form 2210 including part AI. It appears that after I pay 4 regular quarterly taxes this year, I still will have the hassle of filing Form 2210.
However, it appears that if I have my IRA custodian withhold sufficient taxes on my withdrawals (the percentage determined by my last year’s tax burden divided by my estimated taxable income), the hassle of quarterly tax payments and Form 2210 goes away. Am I missing something?
Harry Sit says
You aren’t missing anything. Withholding through employers and financial institutions are treated more favorably to encourage withholding. It’s more reliable for the government.
RobI says
Just discovered this topic while reading the IRMAA topic
One twist on the 4 equal payments of 110% of last years tax is that I could end up overpaying January 15 4th payment (assuming roughly equal taxes yty). Refunds are fine, but rather than give short term interest free loan to IRS I assumed it’s possible to make one smaller payment after you know your income in December, provided you stay above the 90% rule threshold.
Very little has been written about this, but while researching I did learn of an IRS rule that allows you to skip the 4th payment on Jan 15 provided you file and pay taxes in full by Jan 31.
Any comments on this?
Harry Sit says
This is getting into the Make Fewer Things Matter territory. The idea of “Don’t give the IRS an interest-free loan” can be taken too far. Assuming 90% of current year’s tax is less than 110% of last year’s tax, you’re only talking about the difference, and only for 2-3 months. Suppose your total tax is $20,000 in both years and the difference is $4,000 for the January 15 payment, you’ll only earn $50 at a 5% interest rate in three months. That $50 is also taxable. Considering that you’re paying $20,000 in taxes, earning extra $50 before tax from timing the tax payments is a drop in a bucket. Sometimes 110% of last year is higher than 90% of current year, sometimes it’s lower. You win some, you lose some. I wouldn’t worry about it.
If you have investments, brokers usually don’t have their 1099 forms ready before January 31. If they have the forms ready, sometimes they’ll send revised forms later when they find inaccuracies. Tax software often isn’t complete before January 31. I won’t try to file and pay taxes in full by January 31.
Suresh says
Harry,
Thanks for your reply. When you work for somebody, taxes are withheld as you get paid.
But when you are retired, you need to pay more taxes in earlier months though most of your income is in 3 rd. and 4 th quarter.
This is like giving interest free loan to IRS.
So to follow what you said , take my last years total taxes minus all withholding from social Security, pension , RMD and then divide the rest by 4 and pay every quarter. will that work?
Or stop all withholdings and pay 1/4 of last years taxes every quarter.
I prefer the first option if that is okay. I do not want to stop the with holding.
But if I decide to do Roth IRA conversion in 4th quarter, how will that fit in above two methods?
Suresh
Harry Sit says
Take your last year’s total taxes (110% if AGI is $150k or more) minus all withholding from Social Security, pension, RMD, and then divide the rest by 4 and pay every quarter. If you increase withholding from pension or RMD, you’ll cover it entirely by withholding. There won’t be any “rest” and you won’t have to pay estimated taxes. If you do your RMD in the 3rd or 4th quarter, your withholding will also be in the 3rd or 4th quarter. There won’t be an interest-free loan to the IRS.
If you decide to do Roth conversion in the 4th quarter, it doesn’t change your last year’s taxes. Your withholding target is still the same. It will change your withholding target for the following year, but it evens out when you continue doing Roth conversion every year.