by Tricia Bush, CPA, CFP®, Partner, Bestgate Advisors
Understanding Estimated Tax Payments
Who Needs to Pay & How to Stay on Track
For many taxpayers, the process of paying taxes is relatively straightforward. Wages are earned, taxes are withheld from paychecks, and when tax season arrives, most of the heavy lifting has already been done.
However, there are millions of Americans who don’t fit into that traditional mold, and, for them, the concept of estimated tax payments becomes critical. Let’s break down what estimated tax payments are, who needs to make them, and how to ensure you’re staying compliant with IRS rules, especially as the year progresses.
What Are Estimated Tax Payments?
Estimated tax payments are quarterly payments made by individuals who have income that isn’t subject to withholding. This typically includes income from self-employment, rental properties, dividends, interest, capital gains, and even gambling winnings. If you expect to owe at least $1,000 in taxes after subtracting your withholding and refundable credits, you are generally required to make estimated tax payments.
Estimated taxes are paid in four installments throughout the year, typically due in April, June, September, and January of the following year. These payments cover both federal income tax and self-employment tax (for those who are self-employed). If you fail to make these payments or don’t pay enough, you may be subject to interest and penalties.
Who Needs to Make Estimated Tax Payments?
Generally, you need to make estimated tax payments if:
You are self-employed, a freelancer, or an independent contractor.
You receive income from dividends, interest, rental properties, or capital gains.
You earn income from a side business or gig economy jobs.
You have substantial gambling winnings or windfalls that are not subject to withholding.
It’s also worth noting that even if you work a regular job, estimated taxes may still be relevant to you. For example, married couples who both work may have insufficient withholding if they don’t coordinate well. Some taxpayers with higher incomes, multiple jobs, or those who itemize deductions may also find that their withholding isn’t enough to cover their full tax liability, meaning they too may need to make estimated payments.
Safe Harbor Rules: Prior Year vs. Current Year Calculations
The IRS provides a “safe harbor” to help taxpayers avoid penalties for underpaying taxes throughout the year. Essentially, if you meet the safe harbor criteria, you won’t face penalties, even if you end up owing taxes when you file your return.
There are two ways to calculate your estimated tax payments to meet the safe harbor:
Prior Year Safe Harbor: This method allows you to avoid penalties if your total tax payments (including withholding and estimated tax payments) are at least 100% of the tax you owed in the prior year (or 110% for higher-income taxpayers). This is often a simpler approach, as it involves looking at last year’s tax return to determine how much you need to pay.
Current Year Safe Harbor: This method bases your payments on your projected current-year income. If you expect your income to fluctuate significantly from last year (perhaps due to a new business venture, job change, or investment gain), you may want to calculate your payments based on this year’s expected tax liability. To avoid penalties, your payments must cover at least 90% of your projected tax liability.
While these rules provide flexibility, it’s important to stay on top of any changes in income throughout the year and adjust your payments accordingly to avoid falling short.
Income Outside of Wages: Who Typically Needs to Make Estimates?
Aside from self-employed individuals and small business owners, several other groups of taxpayers frequently need to make estimated tax payments.
Investors: Those who have significant income from dividends, interest, capital gains, or other investment earnings may need to make quarterly payments. Even if you’re not actively managing your portfolio, a few well-timed stock sales or unexpected investment income can push you into underpayment territory.
Landlords: If you own rental properties, income from rent or the sale of a property can generate tax liability not covered by withholding. Real estate professionals often find themselves in need of making estimated tax payments, especially if they have substantial depreciation write-offs and other tax strategies in play.
Married Couples: Some married couples may find that their combined wages result in a tax shortfall, especially if both spouses are working but don’t adjust their withholding to reflect their joint income. Additionally, if one spouse earns income from a side business or freelance work, it may exacerbate the issue.
The Withholding Advantage: A Way to Catch Up
If you’re behind on your estimated taxes for the year, there is a useful workaround that many people overlook: increasing your paycheck withholding. The IRS treats tax withheld from your paycheck as being paid evenly throughout the year, even if it’s deducted in large amounts later in the year. This means that if you’re behind on estimated taxes, you can instruct your employer to withhold more tax from your paycheck during the final months of the year to catch up and avoid penalties.
To do this, you’ll need to adjust your W-4 form with your employer to reflect the additional amount of tax you want withheld. You can also make one-time changes or extra payments, especially if you’re expecting a bonus or commission payment.
This strategy is particularly helpful for individuals who have a mix of wage income and income from other sources, such as dividends, rentals, or a small business. By strategically increasing withholding, you can avoid scrambling to make large estimated tax payments at the last minute.
Final Thoughts: Staying on Top of Your Taxes
Making estimated tax payments may seem like a burden, but they are crucial for ensuring that you’re on track with your tax obligations throughout the year. Whether you’re self-employed, earn significant investment income, or have multiple sources of income, understanding your tax liability and staying current with your payments is key to avoiding penalties and interest.
If you find yourself behind, remember that it’s not too late to take corrective action. Whether by increasing your withholding or making catch-up payments, staying proactive will help keep you in the IRS’s good graces and make tax season a little less stressful.
Stay organized, monitor your income changes, and seek professional tax advice if needed to ensure you meet the IRS’s requirements and avoid any surprises when April comes around!
