Every tax season, individuals and businesses find themselves swimming in receipts, W-2s, 1099s, and various tax forms. Sometimes making sense of your taxes seems like a job in and of itself, especially if you discover that you owe money come filing time.
If you owed money after filing, the government likely requested that you make estimated quarterly payments during the next tax year. By paying quarterly, you avoid penalties and shouldn’t owe at the end of the year.
This article will provide an overview of what quarterly estimated taxes are, who pays them, how corporations and individuals calculate them, and strategies for paying them.
What are estimated quarterly taxes?
The United States has a “pay as you go” tax system. This means that you must pay taxes when you receive income, as opposed to paying it all at the end of the year. However, you do not have to pay taxes every time you receive income. Instead, you can make tax payments in quarterly installments.
The IRS says, “if the amount of income tax withheld from your salary or pension is not enough, or if you receive income such as interest, dividends, alimony, self-employment income, capital gains, prizes, and awards, you may have to make estimated tax payments. Estimated tax is used to pay not only income tax but other taxes such as self-employment tax and alternative minimum tax.”
Who pays estimated quarterly taxes?
Independent contractors, sole proprietors, limited liability companies, partners, and S corporation shareholders may all be responsible for paying quarterly taxes.
There are a few additional qualifiers that determine whether you’re responsible for making quarterly payments. An individual who expects to owe less than $1,000 in taxes after subtracting federal income tax is exempt from quarterly tax payments. For corporations, the threshold is $500 in taxes annually. Additionally, if your federal tax withholdings equal 90% or more of what you will owe for the year, you probably won’t need to file quarterly taxes.
Penalties for non-payment or late payment
The IRS can penalize individuals and corporations who don’t file quarterly taxes when they’re required to do so. The IRS says, “We calculate the penalty separately for each required installment. The number of days late is first determined and then multiplied by the effective interest rate for the installment period.” Generally, the IRS charges a fee of 0.5% per month.
Penalties as high as 6% can also apply if you underpay your estimated taxes, so independent contractors and businesses should make sure they’re paying estimated quarterly taxes accurately.
How to estimate your quarterly taxes
You pay federal income taxes on a pay-as-you-go basis. 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 giving the government an interest-free loan that can’t be recouped until you file your return. Fortunately, the IRS provides worksheets to help you calculate quarterly taxes accurately. You can also find resources on the TurboTax site. And QuickBooks Self-Employed can help manage your deductions and calculate quarterly tax payments for you.
How to pay quarterly taxes
One of the biggest struggles with quarterly taxes is not having cash on hand to pay them. Business owners will likely use their income to do things like pay creditors and make investments to grow the business. Business owners and independent contractors must remember that anything they earn is taxable income. They should set funds aside to pay the taxes due.
To determine how much you should pay each quarter, you’ll want to calculate your owed quarterly tax amounts. For individuals, figure out your estimated quarterly tax payments using Form 1040-ES. Individuals can use IRS Form 1040-ES to submit quarterly taxes. Corporations can use Form 1120-W to provide quarterly payments.
You can simplify your payment process by linking your bank account to EFTPS.gov, otherwise known as the electronic federal tax payment system.
States also have their own payment system where you can pay off your taxes due. You can set up a direct debit so that funds are withdrawn automatically. You can also pay with a credit card, although there is a service fee associated with doing so. The 2019 Quarterly Due Dates are:
- Q1: April 15 due date for income from January 1 to March 31
- Q2: June 15 due date for income from April 1 to May 31
- Q3: September 15 due date for income from June 1 to August 31
- Q4: January 15, 2020 due date for income from September 1 to December 31
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’re 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 depends on your personal circumstances and tax rate. Consider setting aside at least 30% to account for your income tax, Social Security tax, and Medicare tax.
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.
Work with a tax professional
Your CPA or other tax professional can monitor your income and expenses. They can provide you with tax advice about changes you need to make to your estimated tax payments.
Other things to consider
When paying quarterly taxes, there are a few things that you’ll want to keep in mind. Doing so can reduce the total tax you owe at the end of the year.
Make sure payments cover all of the taxes you owe
Besides income taxes on your business earnings and other sources of income, estimated taxes should include projected liability for the following types of federal and state taxes.
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 $132,900 are taken into account in figuring self-employment tax in 2018.
Alternative minimum tax (AMT)
You’ll pay this if your tax is more than your regular income tax. The AMT, which is figured using different rules rather than consistent tax rules, is intended to make sure those able to reduce their regular burden through various exclusions and deductions pay at least some income tax. The IRS details how to determine if this applies to you.
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 you’re single, $250,000 if you’re married filing jointly, or $125,000 if you’re married filing separately.
Net investment income tax of 3.8%
This tax applies to the lesser of your adjusted pre-tax income over a threshold amount, or your net investment income. For pre-tax income, the threshold is $200,000 if single, $250,000 if married filing jointly, or $125,000 if married filing separately.
Net investment income equals investment income minus investment expenses. Investment income includes profits from dividends from stocks, interest earned from bank accounts, and capital gains from property sales. 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, you are an employer who must pay FICA and FUTA (federal unemployment) taxes on the worker’s wages over set amounts.
Rely on safe harbors
If you represent a corporation, there are a couple safe harbor methods you can use to avoid penalties. First and foremost, you can pay 100% of the actual tax that the company owes for the current year. Additionally, corporations can pay 100% of the tax owed from the previous year. If the corporation did not owe tax the year prior, it must pay 100% of the current year tax for a safe harbor.
If you’re an individual, the law gives you a little leeway to pay estimated taxes. The IRS 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.
Pay 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. There’s also a special rule for farmers and fishers.
Pay 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. If your adjusted gross income last year was more than $150,000 ($75,000 for married persons filing separately), the prior-year percentage increases to 110%. So if you owed $5,000 in taxes, you’ll need to pay at least $5,500 in total quarterly payments to avoid a penalty.
If your income this year is the same or higher than last year, the 100% prior-year safe harbor is the easiest and safest strategy for figuring estimated tax.
No computations are needed. You can 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, probably doesn’t make sense if you expect this year’s income to be less than last year, because you’ll overpay your taxes.
Use the 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.
This method works best for those whose income varies throughout the year. If your business is seasonal or you receive work during specific periods of the year and little to no work at other times, then the annualized income installment method is the right choice.
This method gives independent contractors a bit more leeway in the instance of an underpayment so that penalties may be reduced or waived. You should use the annualized income method to estimate your state income taxes too.
Rely on income tax withholding
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 or her withholding to cover your anticipated estimated taxes.
- You have a W-2 earning job: Business owners, especially those with side 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’s elected 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, you should monitor your income and expenses throughout the year so that you can make adjustments in estimated tax payments.
You may need to increase the remaining payments to avoid underpayment penalties. Alternatively, you may be able to reduce the payments and hold onto your cash. Reasons you could reduce payments include:
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, let’s say that when you paid your first and second installment 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 percentage of benefits could be 50% higher than initially expected. 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, adoption of a child, or other changes in individual 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 instance, after the new tax law went into effect last year, the IRS waived penalties for many US citizens.
Tax laws are subject to change
Perhaps the best lesson to learn when discussing quarterly payments is that tax laws will change from year to year. Whether you’re an independent contractor or small business owner, you’ll want to stay up-to-date on current tax laws and IRS regulations. A variety of business-oriented websites publish articles regarding these changes. QuickBooks publishes articles relating to these changes in December and January.