Federal income taxes are paid on a pay-as-you-go basis. If you don’t have wages from which withholding taxes can be taken, the burden is on you to pay estimated taxes four times a year—April 15, June 15, September 15 and January 15 of the following year—to cover your anticipated tax bill. Underpaying your taxes triggers a penalty, while overpayment is the equivalent of an interest-free loan to the government that can’t be recouped until you file your return. Here are some strategies to help you figure what you owe.
Make Sure Payments Cover All Taxes Owed
Besides income taxes on your business earnings and other sources of income, estimated taxes must include projected liability for:
- Self-employment tax on your net earnings (profits) from self-employment. Remember that the wage base on the Social Security portion of the tax can change each year. For example, net earnings from self-employment up to $118,500 are taken into account in figuring self-employment tax in 2015, compared with $117,000 in 2014.
- Alternative minimum tax (AMT). This tax is paid if it is greater than your regular income tax. The AMT, which is figured using different rules than regular tax rules, is intended to make sure that those able to reduce their regular tax through various exclusions and deductions pay at least some income tax.
- Additional Medicare of 0.9% on your earned income. This tax applies if your wages and net earnings from self-employment exceed $200,000 if single, $250,000 if married filing jointly, or $125,000 if married filing separately.
- Net investment income tax of 3.8%. This tax applies to the lesser of your adjusted gross income over a threshold amount ($200,000 if single, $250,000 if married filing jointly, or $125,000 if married filing separately) or your net investment income (investment income minus investment expenses). Investment income includes your share of profits from a business in which you do not materially participate. It does not include business income if you materially participate (i.e. you are active in the business’s day-to-day activities).
- Employment taxes on a household employee. If you have a nanny or other domestic worker in your home, as an employer you must pay FICA and FUTA (federal unemployment) taxes on the worker’s wages over set amounts.
Rely on Safe Harbors
The law gives you a little leeway in paying estimated taxes, and won’t impose a penalty if you fall short by less than $1,000. There are other ways to avoid an estimated tax penalty, and you can use them to set your estimated tax payments for the year:
- 90% of the tax owed for the current year. Project what you expect to owe and pay 90% of this in four installments. As long as your estimated tax payments wind up being 90% of your final tax bill, you won’t owe any penalty. Note: There’s a special rule for farmers and fishermen.
- 100% of last year’s taxes. Look at what you paid last year and divide by four to fix your estimated installments for the year. Note: If your adjusted gross income last year was more than $150,000 ($75,000 for married persons filing separately), the prior-year percentage is 110%.
- Annualization method. If your income changes later in the year, you can increase payments without penalty as long as your earlier payments were correct, based on income in those periods. You can’t simply choose to make a large payment for your fourth installment if you underpaid the earlier installments.
If your income this year is the same or greater than last year, the 100% prior-year safe harbor is the easiest and safest strategy for figuring estimated tax. No computations are needed; just look at the total liability for last year’s return to set this year’s estimated tax payments. Just be prepared to make up any shortfall in your taxes for the year when you file your return. This strategy, however, probably doesn’t make sense if you expect this year’s income to be less than last year, because you’ll overpay your taxes.
You may be able to rely on income tax withholding if one or more of these apply:
- You have a working spouse. If you have a spouse with a job, your spouse can increase his/her withholding to cover your anticipated estimated taxes.
- You have a W-2-earning job. Business owners, especially those with sideline businesses, may have part-time or full-time jobs. Again, figure withholding from your wages to cover the tax on your business income.
- You have an LLC that is electing S corporation status. If you have a limited liability company, you can opt to be taxed as an S corporation. This enables you to take a salary, and have withholding taken to cover the taxes on your salary as well as your share of business profits.
Adjust as You Go
If you don’t use the prior-year safe harbor, it’s advisable to monitor your income and expenses throughout the year, so you can make adjustments in estimated tax payments. You may need to increase remaining payments to avoid underpayment penalties. Alternatively, you may be able to reduce the payments and hold onto your cash.
- Changes in business income. Most business owners see their income and expenses fluctuate throughout the year. Minor fluctuations probably won’t affect estimated taxes. However, a significant change—positive or negative—can affect remaining payments for the year. For example, when you paid your first and second installments of estimated tax for the year, you expected your share of the profits from your limited liability company to be $100,000. Then business really picked up and your anticipated share of profits could be 50% higher than originally expected. Therefore you should adjust your third and fourth installments to take the added tax on this income into account. (See the annualization method discussed earlier.)
- Changes in personal circumstances.A marriage, divorce, birth or adoption of a child or other changes in personal circumstances can affect tax liability and estimated taxes, so make adjustments accordingly.
- New tax laws. Make adjustments if there are law changes during the year that affect your taxes. For example, various favorable tax rules expired at the end of 2014. If they are extended for 2015, this may lower your tax bill, and your estimated tax payments that are still outstanding for 2015.
Be Prepared for Payments
Perhaps the most challenging part of estimated taxes is having the cash on hand to make the payments when they come due. Business owners that have cash flow issues may be highly tempted to pay creditors, make investments to grow the business or use money for purposes other than estimated taxes. This can lead owners to ignoring or underpaying estimated taxes, resulting in a downward spiral of noncompliance with tax obligations. Interest and penalties can build up on taxes that go unpaid.
To avoid this dire result, make sure you’re in a position to pay estimated taxes when they come due. In addition to implementing accounting software that can help manage your expenses and calculate your estimated taxes, be sure to keep in mind the following tips:
- Recognize that income is not fully spendable. Like employees who have taxes taken automatically from their paycheck, those paying estimated taxes must do their own “withholding” from revenue. For example, if you are a self-employed freelancer receiving a fee of $1,000, a portion must be viewed as withholding for estimated taxes. How much should be “withheld?” It depends on your personal tax picture. Consider setting aside 10%, 20% or even more, and remember to factor in offsetting deductions you expect to use when figuring your net income on which taxes are figured.
- Create an “estimated taxes” account. Segregate funds for estimated taxes from your other business funds and hold the segregated funds in a separate bank account. This will prevent you from using the money for other purposes. Doing this also simplifies the payment process because you can link the account to EFTPS.gov, an online payment system that allows you to schedule and pay your federal estimated taxes.
- Work with a tax professional. Your CPA or other tax professional can monitor your income and expenses and advise you on changes you need to make to your estimated tax payments.
Making valid deduction claims on your annual tax return is just as important as timely tax payments throughout the year. Click here for a few more deductions you may have missed, and see our article on ways to avoid an audit when filing 1099s.
For more tax-time tips, see our complete guide to taxes for the self-employed.