You know what they say about death and taxes. If you work for an employer, the IRS requires the employer to withhold taxes. If you don’t have an employer, you will have to pay taxes on your own, and 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.”
I had worked as both a W-2 employee and self-employed for a long time. In the past I just had my employer withhold extra to cover the taxes owed on my self-employment income. This is easier 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. By October I had a good idea how much I would earn from my self-employment in that year. I then requested my employer to withhold extra from my paychecks.
Base On Prior Year Or Current Year
After I left my full-time job last year, I’m now completely on my own. In order 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 easier 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 from line 15 of your 1040 form. Then you just take 100% or 110% of that amount as your target this year. It also works well when your income is going up. Even if you pay 110% of your last year’s tax, it won’t be too far off from your tax on a higher income.
However, when you expect a large drop in income, such as the case for me this year, paying based on previous year’s tax will be way off. So I’m left to guess what my income will be this year, and then calculate what my tax will be from there. Fortunately they do allow a 10% buffer. If I guess wrong, as long as I pay more than 90% I will be OK.
If you use downloaded/installed tax software instead of the online service, it’s very easy to estimate your tax based on your estimated income. Just make a copy of last year’s tax file, open it, and change the income numbers to your estimates. If you don’t have installed tax software, the Case Study Spreadsheet (aka Personal Finance Toolbox) can help, but you will have to learn how to use it. See Tax Calculator With ACA/Obamacare Health Insurance Subsidy.
After this year I will go back to using prior year’s tax as the target, which doesn’t require guessing the income or running software.
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.
Even if you earn 100% of your income in January, you can still pay in four equal installments. If you earn 100% of your income in December, they don’t expect you to have the foresight for what your annual income will be at the earlier due dates. You can pay less early in the year and more later in the year when your income also skews more toward later in the year. So just do the best you can in estimating your annual income and your tax at each due date. If you have a larger income later in the year, just pay more to catch up.
State Income Tax
The state wants their taxes too. I live in California, which has the same due dates as the IRS, but they have an accelerated collection requirement. Instead of 1/4 each at each due date, California requires 30% of the annual tax due on April 15, another 40% on June 15, and a final 30% on January 15 of the following year. This way California gets paid more sooner. By June 15, California will have already received 70% of the annual estimated tax.
The tax authorities make it relatively easy for you to pay your taxes. The IRS offers Direct Pay for one-time payments. No login or password is required. You just pay with a bank account. For scheduled 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 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.
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 day 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 at 2% of the payment amount with no cap. California also charges a similar dishonored payment penalty. Bouncing those two debits can cost a small fortune!