Who Pays Estimated Taxes and Why?

by Michael on Sep 19, 2013

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As I noted a few days ago, estimated tax payments for the 3rd quarter of 2013 were due at the beginning of this week. That’s all well and good, but…

Have you ever wondered who has to pay estimated taxes and why? I’ve touched on this in passing, but decided it was worthy of a post of its own. So, here goes… 🙂

According to IRS Tax Topic 306:

The United States income tax is a pay-as-you-go tax, which means that tax must be paid as you earn or receive your income during the year. You can either do this through withholding or by making estimated tax payments. If you do not pay your tax through withholding, or do not pay enough tax that way, you might also have to pay estimated taxes.

The reality is that most Americans fulfill their pay-as-you-go obligations through income tax withholding on their paycheck. But even if you work a regular job — and especially if you don’t — you might need to make estimated payments to avoid triggering underpayment penalties.

Consider the case of the freelancer who doesn’t have any “regular” W-2 earnings, and thus no withholding. Or the small business owner who sells their business in the middle of the year. Or even the mid-career worker with a sizable investment portfolio and significant dividend earnings.

Note: While it’s never fun to fill out tax paperwork, having to make estimated tax payments due to outsized investment income is something that everyone should be looking forward to. This is a very good problem to have.

In all of these cases, it’s likely that you’ll need to make estimated payments or face the consequences (use IRS Form 2210 to calculate the damage). In fact, you’ll be subject to an underpayment penalty unless you:

  • owe less than $1k in taxes at the end of the year after subtracting your withholding, estimated payments, and tax credits;
  • have paid in at least 90% of the tax due for the current year; or
  • have paid in at least 100% of the tax shown on your return for the previous year

This latter amount is known as the “safe harbor” amount and targeting that value is by far the safest and easiest way of avoiding penalties. In the other cases, you’re essentially shooting at a moving target, and it’s easy to miss — though if you’re at least closet the penalties shouldn’t be too bad.

Alternatively, if you work a regular job and are concerned about underpayment, you could always adjust your income tax withholding. This is an inexact science, but it can make quarterly payments unnecessary, so it’s worth considering.

For the record, estimated tax payments are due on the 15th of Apr, Jun, Sep, and Jan, or the next business day in the case of weekends or holidays. Note that these dates aren’t spaced evenly through the year, so be careful.

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