Most taxpayers are familiar with paying their income tax sometime in April. However, the U.S. tax system is on a pay-as-you-go basis. That means, for anyone earning meaningful income from non-wage income sources, a quarterly estimated tax payment might be necessary. That’s because, unlike a paycheck from an employer, there is no automatic tax withholding applied to most other income sources.
If timely quarterly estimated tax payments are not made, there may be penalties and interest to pay, cash planning will be difficult, and a taxpayer’s good standing with the IRS could be lost.
This article will help provide more detail about that process and allow you to assess whether you should be making quarterly payments. We will describe the following:
- Who needs to make an estimated tax payment
- Calculating the minimum required quarterly payment
- How Visor can help
Who needs to make quarterly estimated tax payments?
Anyone who expects to owe tax of $1,000 or more when their return is filed should consider making quarterly estimated tax payments. That’s the amount at which the IRS might penalize you for underpaying your taxes throughout the year.
Payments are made four times over the course of the year, in April, June, September, and January. You can find 2018’s deadlines for quarterly payments here.
If you received income from the below activities, you will probably need to review your options and potentially plan on making a payment to the IRS:
- Self-employment: This includes contractors, business owners, consultants, freelancers or members of the gig-economy such as Uber/Lyft drivers.
- Rental income: Such as from renting out a second home/apartment or serving as an Airbnb host.
- Investment income: Earned from dividends, interest, capital gains on sales of stock, and K-1 income for those with interests in partnership or investment vehicles like hedge funds, private equity, or venture capital.
Using back of the envelope math, if your tax rate is about 25-35%, then if you earn about $2,800-$4,000 or more of non-withheld income, you likely are going to cross the $1,000 tax liability threshold.
How much do I have to pay?
If your goal is solely to avoid an underpayment penalty, the IRS provides two options for calculating ‘acceptable’ payment amounts.
Here is what we will need for the two calculations:
- Your expected income (less deductible expenses) for the current year
- Total tax you owed last year (found on last year’s tax return)
- Adjusted Gross Income (AGI) from last year (also found on the tax return)
We use those inputs to calculate the amount you must pay, which is the smaller of:
- “Estimated Actual”: 90% of your total expected tax for 2018, or
- “Safe harbor”: 110%* of the total tax shown on your 2017 return.
- *If you earned less than $150,000 in 2017, you can substitute 100% for 110%
Making the payment
After total tax is estimated, 25% is paid to the IRS each quarter. You will need to revisit this calculation each quarter if you have uneven income or expenses as changes to the assumptions will likely impact the payment amount per quarter.
You may also choose to pay more than the minimum required. For instance, if you determine that your tax liability for 2018 will be $20k but you are only required to make four payments totaling $18k, then you will be stuck paying the remaining $2k with the filing of your return. It is up to you to choose whether to pay the minimum safe amount or to pay in full with each quarter’s estimated payment.
Once you’re ready to make the payment to the IRS and/or state, the easiest option is to do this online via: IRS Direct Pay or EFTPS.gov (your state likely has an online portal too). You can always send a check in the mail if you want to avoid making tax payments with a debit or credit card because of payment processing fees.
Additional important reminders:
- Self-employment tax: if you are self employed, you have to remember to pay estimated Social Security and Medicare taxes (collectively known as “FICA”) along with your income tax estimates. This is another 15.3% that should be factored into the above tax calculation.
- State income tax: States also have to get their fair share and many states have unique rules for paying those taxes. A tax advisor can help you navigate your specific state rules.
There are two significant downsides to ignoring your estimated tax payments:
- Penalties: There are penalties for not paying your estimated payments on time. The current penalty is 4% of the underpayment, compounded monthly, until the day its paid.
- Cash Flow: If you put off making your payments now, you can expect to owe a significant amount of taxes when you file (plus the penalties we just mentioned above). If you have not planned correctly, this tax liability might hurt. We hate to see our clients get caught with an unexpected tax bill, which is why we always recommend making payments quarterly as it’s much easier to budget appropriately.
Tax advisors can help you figure out how much you owe and advise you on the best way to set up your estimates. There is a lot of flexibility with how to approach these payments, so a good tax advisor will take into account your personal preferences for budgeting and cash flow management, not simply the tax code rules.
Visor provides year-round tax planning for just these sorts of situations. We work to adjust your tax payments to fit your needs. The goal is to save you time and money, leaving you in the best position possible.
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