What Are Estimated Tax Payments?

Has your tax professional suggested making “estimated payments”? Do you ever wonder what he or she is talking about? What are estimated payments? Why do I have to make them? Will I get in trouble if I don’t make estimated payments?

What are Estimated Payments?

Estimated payments are generally suggested when the withholding from your paychecks or retirement plan distributions are not enough to cover taxes owed from all of your taxable income. This usually happens when you have income from sources where taxes are not withheld, like self-employment income, income from partnerships and S-corporations, retirement plan distributions, and unemployment. You can also get into a situation where tax withholding on your paychecks is not enough when you are married and both spouses are employed with W-2 income. Click here for this article to help understand that situation.

Why Should I Make Estimated Tax Payments?

There are two reasons to make estimated tax payments. The first is to avoid or limit late payment penalties from the IRS and state. The IRS and all states expect to receive payments throughout the year. This is achieved through withholding on paychecks and estimated payments. By having enough in paycheck withholding or making enough estimated tax payments on time, you will avoid or limit pate payment penalties.

The second reason is to avoid a large tax bill when you file your tax return or file for an extension. This may be more psychological than anything; most don’t like the prospect of having to pay thousands of dollars in the future and would rather pay earlier in smaller amounts.

When are Estimated Tax Payments Due?

Estimated tax payments are due April 15, June 15, and September 15 of the current year, and January 15th of the following year. Most states also follow this schedule as well, but be sure to check on your state’s specific requirement.

What if I don’t make them?

If you don’t make estimated payments and you owe when your return is filed, you may not face penalties if you have paid enough through withholding and estimates under the IRS “safe harbor” method. This can get complicated but if you paid either 90% of your tax bill, or an amount equal to 100% of your prior-year tax bill (110% if your adjusted gross income was above certain levels), you won’t face any penalties if you make up the balance by April 15th of the year your return is due. This payment is made either with the filing of the return or the filing of an extension.

If you don’t fall under the safe harbor exception, the IRS will calculate penalties at the rate of 3% on an annualized basis for any payment due, but not paid. The penalty is not 3% of the balance owed. It ends up being less than that because the penalty is based on 1) when each payment was due, and 2) what the required estimated payment was. If you don’t make a payment of estimated taxes due if you file for an extension (known as an extension payment), the IRS adds another penalty calle a Failure to File Penalty which runs 0.5% per month and this is on top of the underpayment interest. Click here for an article that goes into more detail on this.

Most states follow a similar calculation but, often, their penalties can be much higher.

Hopefully, this article helps with a basic understanding of estimated tax payments, what they are, and why they should be made. If you have any questions, comment below or send us an email.