Many of our clients make estimated tax payments. Part of our job is to help them determine when to make these payments and how much to pay. What are estimated taxes and how do they apply to you?
What are estimated taxes?
If you’ve ever received a paycheck that had federal or state income taxes withheld, you’ve participated in “pay-as-you-go” tax collection. A certain amount in tax is withheld from regular paychecks throughout the year; you true this up to your actual tax liability when your tax return is filed in the following year. If the amount of taxes withheld is less than your tax liability, you will owe the difference. If the amount of taxes withheld is more than your tax liability, you have an overpayment that’s generally available to be refunded. The cycle starts again each January 1.
In many cases, income tax withholdings are insufficient to cover a taxpayer’s tax liability. In other cases, withholdings are absent entirely. This doesn’t excuse the taxpayer, however, from the pay-as-you-go regime. Estimated taxes are the mechanism by which folks in these situations send tax dollars to the IRS and other taxing authorities in cases of insufficient withholding or no withholding at all.
Who makes estimated tax payments?
Estimated tax payments are made by folks with no withholding. Self-employed individuals who have no withholding from payments made to them by their customers are one example. Retirees who are generating significant investment income on which there is no withholding are another example.
Estimated tax payments are also made by folks with insufficient withholding. For example, remitting estimated taxes may be advisable when your employer is withholding at a much lower tax rate than your expected tax rate.
Estimated tax payments may be advisable in other circumstances, as well.
When are estimated tax payments due?
Estimated tax payment due dates are set by the IRS. Although they’re commonly referred to as “quarterly estimates” as there are four payments in a year, actual payments are due on a slightly different schedule than once every three months. Estimated tax due dates for personal taxes are April 15th, June 15th, September 15th, and January 15th. For example, if you’re making estimated tax payments for 2022, estimated tax payment due dates will be:
- April 15th, 2022
- June 15th, 2022
- September 15th, 2022
- January 15th, 2023
Why make estimated tax payments?
It certainly requires some effort to determine at what level and when to make payments, in addition to actually making the payments either online or via mailed check. And, of course, all this is really guesswork as you won’t know your actual tax liability until sometime the following year. Why not just pay the next year when you file your tax return?
The main reason estimated tax payments are often advisable is to avoid or minimize underpayment penalties. If you didn’t already guess it, you’re likely not surprised to learn that the IRS and state taxing authorities assess charges if you don’t pay taxes that should have been remitted under the pay-as-you-go system. The use of the word “penalty” in this context is a bit of a misnomer. Underpayment penalties actually function more like interest on a loan. If you don’t make estimated tax payments or don’t make them at the levels the IRS expects, the IRS asserts it gave you a loan while you held onto those tax dollars, so you’re charged interest on that loan.
How do I know how much to pay?
To avoid or minimize underpayment penalties, you generally must pay via withholding + estimated tax payments a certain percentage of either a) your current year tax liability, or b) your immediately prior year tax liability.
For federal tax purposes, these percentage are 90% of your current year tax or 110% of your prior year tax (or 100% of your prior year tax if your income was under a certain level). States may have their own rules, and some do not even require estimated tax payments at all.
In general, the goal is to pay in as little as possible in advance based on these percentages while still having an idea of the unremitted balance that you’ll need to pay in the following year when your tax return is filed. Although making estimated tax payments is optional subject to underpayment penalties, taxing authorities expect payment in full by the return’s original due date, usually April of the following year. Payments made after this date start accruing late payment penalties and interest, in addition to any estimated tax underpayment penalties that may apply.
Should I make estimated tax payments?
That’s the question! This answer is different for each taxpayer from year-to-year, even quarter-to-quarter. Changes in income levels, types of income, timing of income, expected withholdings, prior year overpayments, changes to tax laws, etc. all factor into projecting expected tax liabilities which is a key component in determining when, and at what level, to make estimated tax payments. For Atlanta.Tax clients, addressing the questions surrounding estimated taxes is part of the tax planning process.
Additionally, your ability and interest in paying estimates can be impacted by:
- Cash flow – Is your business activity volatile? Do you need cash for a home purchase down payment or other purpose? If your cash position is uncertain, you may feel more comfortable holding onto your money longer at the expense of incurring underpayment penalties.
- Time of year – Most folks are less inclined to make payments earlier in the year when expected tax liabilities can be vague.
- Are you a good saver? – If not, you may want to make those estimates to avoid spending tax dollars and winding up short the following April.
- Risk tolerance – Some people can’t sleep at night thinking they owe the government money.
- Amount of income you can generate on funds that would go toward tax payments – If this is close to or higher than underpayment penalties, you may be less inclined to pay estimates. IRS underpayment penalty rates are adjusted quarterly, and as of this writing are 3%.
- Prior dealings with taxing authorities – You may feel more or less inclined to prepay your tax obligations depending on the status of installment agreements, etc.
- Your opinion of current political and economic climates – If you see instability, you may be less inclined to give your money to the government sooner than you absolutely have to before incurring late payment penalties and interest.
We can help!
Whether it’s advisable for you to make estimated tax payments is based on a number of factors, many of which are specific to you and that can change over time. We’re happy to assist you with any questions you have regarding estimated taxes, including helping you determine if, when, and at what level estimated tax payments may be advisable for your specific tax situation.
(Article originally published July 19, 2019. Updated August 10, 2020.)