The gig economy is here to stay, and more people than ever are earning money through self-employment or contract work. For taxpayers who get a portion or all of their income from self-employment sources, knowing the rules of estimated taxes can save them a big headache—and financial penalties—come tax time.
One of the biggest challenges with this kind of income is that it can be unpredictable. If you’re selling holiday decorations on Etsy, for example, you may make far more income at the end of the year than you do at the beginning. Other people choose to put in hours based on their needs, so in months with high expenses they may work more hours to help offset extra expenditures.
When your income isn’t steady, how can you make accurate quarterly estimated tax payments? Underpaying can cause financial penalties, but overpaying means the government holds on to your hard-earned cash until tax refund season.
With IRS Safe Harbor tax rules, you can make estimated tax payments and avoid penalties despite having a highly variable income stream.
What are Safe Harbor Tax Rules?
Every taxpayer is obligated to pay taxes on their income throughout the year. For W-2 employees, this federal income tax is paid through withholding on each paycheck. For self-employed or contract workers, these taxes must be paid quarterly through estimated tax payments.
Estimated payments may be required for many sources of income—not only income tax for wages, but also self-employment tax for Social Security and Medicare. Even W-2 employees may be required to pay estimated taxes if they experience a windfall during the year, including major capital gains, the sale of a business, or other similar unanticipated sources. Failing to pay estimated tax on income like this can result in financial penalties on your tax return.
The safe harbor rule is meant to protect taxpayers from penalties in the event of unexpected or unpredictable income. While you can’t always perfectly plan out those estimated taxes, you can avoid penalties as long as you meet at least one of the following conditions:
- You owe less than $1,000 in taxes for the current year after applying withholding and credits.
- You pay at least 90% of your owed income taxes for the current year.
- If you pay an amount equal to 100% of the previous year’s owed income taxes through estimated tax payments. (For taxpayers with an expected adjusted gross income of $150,000 or more, this bumps up to 110% of the previous year’s owed taxes.)
Each state also has its own safe harbor rules for state income taxes. For example, Maryland says you can avoid penalties if you owe less than $500 after applying withholding and credits, or if you have made estimated payments equal to 110% of last year’s owed taxes.
Ways to Benefit from Safe Harbor Rules
If you’re feeling a bit lost, then some examples should make it clearer.
Let’s say you’re a regular W-2 employee who has their income tax withheld, so you typically do not pay estimated tax. Unexpectedly, your company files for an IPO and you get a significant windfall through your company stock options, which you exercised. You will owe capital gains tax on that windfall, and you will likely owe a penalty if you don’t take action.
You can make a larger payment to ensure that you cover at least 90% of your tax bill for this year, resulting in a normal payment or refund on your tax return. Alternately, you can make a payment so that you have covered 110% of the total tax liability that you owed last year. In this scenario you will still have to pay the rest of the capital gains at tax time, but you will not owe a penalty for underpaying estimated tax.
Or, consider a self-employed individual, like a ride-share driver or hobby farmer. A ride-share driver might make far more income in the summer than in the winter, while a hobby farmer might receive the bulk of their income during harvest season. It’s very difficult to make estimated payments when you have a high season and a low season. If you have no idea where your income for the year will end up, it’s best to make estimated tax payments based on last year’s income: either 100% or 110% of the previous year’s tax liability, depending on how high you expect your income to be.
When in doubt, it’s always a good idea to consult a tax professional for help figuring out what a good estimated tax payment would be. They can help you understand if you’re at risk for income tax underpayment penalties, and how to make adjustments now via estimated tax payments.
Contact S.H. Block Tax Services For Help with Safe Harbor Rules
If you’ve newly started a side gig and need advice on making estimated tax payments, or you have received an unexpected windfall and want to avoid tax penalties, give us a call. We can help you make a plan for how much money to set aside for estimated tax payments, or make a plan for utilizing safe harbor rules to avoid an underpayment penalty.
Some people are also surprised to find out that “quarterly estimated payments” are not due every three months, but are typically due on the 15th of April, June, September and January. This means that payment can be due before the quarter is over. Getting a good estimate and making sure you don’t miss the payment date are important steps to avoiding penalties.
For these tax questions and more, give us a call at (410) 872-8376 or fill out this form and we’ll start devising a strategy to help you stay current with your tax payments, and avoid paying anything unnecessary.
The content provided here is for informational purposes only and should not be construed as legal advice on any subject.