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.
Timing
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.
Paying Online
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!
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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.