If you seem to find yourself stuck paying estimated tax penalties year after year, you can take some comfort knowing you’re not alone. In 2015, which was the last time the IRS released data on estimated tax penalties, the agency reported that they assessed these penalties on 10 million taxpayers. On average, each of those 10 million taxpayers had to pay about $130 in penalties.
One of the biggest reasons so many taxpayers face these aggravating penalties is that it’s not always easy to accurately estimate your tax liability for the coming year. Many people who pay estimated taxes because their income isn’t subject to withholding also experience significant income fluctuations — whether they’re investors, freelancers, or self-employed individuals.
To help you get off the annual rollercoaster of estimating (or underestimating) your tax liability and facing penalties for underpayment, we’ve put together three helpful tips that can make life easier and smooth out the process of paying estimated taxes.
#1: Pay Your Estimated Taxes Based on What You Owed Last Year
To avoid an underpayment penalty, you need to make sure that the total amount of estimated taxes you pay during the year equals at least 90 percent of what you owe in taxes for the current year or 100 percent of what you owed in taxes last year.
Nobody likes sending extra money in their tax payments, so many people try to “thread the needle” and estimate payments to hit the 90 percent mark on the nose. However, this can be challenging for freelancers and business owners whose revenues ebb and flow from year to year. It also presents problems for people who derive income from investments like stocks whose returns are hard to predict.
One surefire way to get around this problem is to simply use last year’s tax liability and plan to pay 100 percent of that amount in estimated payments this year. Take the amount you owed in taxes last year, divide it by four, and presto — you’ve got your four quarterly estimated tax payments for the current year. If you make these payments on time, you won’t face any penalties for tax underpayment.
However, there are two important details you need to keep in mind if you use this method to estimate your taxes for the year:
Make sure to go by taxes owed and not taxes paid
If you’re using last year’s tax liability to estimate payments for this year, then you need to go by the total amount of taxes you owed, not the amount you actually paid to the IRS when you filed.
As an example, let’s say you owed the IRS $15,000 in taxes last year and paid $14,000 in estimated taxes during the year. When you filed your 1040, you sent the IRS a check for $1,000 to pay the remaining tax liability.
If you want to use last year’s tax liability to pay estimated taxes this year, you need to take the total amount you owed in taxes for the entire year — in this case, $15,000 — and divide it by four to calculate your monthly payments. If you try to pay estimated taxes based on the $1,000 you paid at tax time, your estimated payments will be far too low, and you’ll be in for a nasty surprise at tax time next year.
The rules are slightly different for higher incomes
If your adjusted gross income (AGI) is $150,000 or more ($75,000 or more for married taxpayers who file separately), then instead of paying 100 percent of last year’s total tax liability in estimated payments to avoid a penalty, you’ll need to pay 110 percent.
So, if you made $160,000 in AGI last year and your total tax liability for that year was $40,000, you’ll need to pay at least $44,000 in estimated tax payments this year, assuming you want to base your estimated tax payments on the previous year’s liability.
RELATED BLOG ARTICLE: How to Determine and Pay Estimated Quarterly Taxes
#2: Make Annualized Estimated Tax Payments
For people whose income changes from month to month and season to season, making estimated tax payments can burden them during lean times. However, the IRS offers a solution to this problem: annualized payments.
Instead of paying your estimated tax liability for the year in four equal-sized quarterly payments, the annualized payment method lets you make estimated payments that reflect the flow of your business during the year.
So, let’s say you run a profitable snowplow business that generates most of its revenue during the fall and winter. If your plow company makes $20,000 per year but almost all of that income comes in toward the end of the year, making annualized payments can help you avoid a big summer tax payment that you don’t have the cash flow to handle.
However, keep in mind that making annualized payments requires more work and record-keeping than simply making four equal payments. You’ll need to monitor your income and expenses throughout the year and base your estimated tax payments on these figures each quarter. And regardless of which method you choose to come up with your estimated tax payments, you still need to pay estimated taxes on at least 90 percent of your income for the year to avoid penalties.
#3: Increase Workplace Withholding
Most people who pay estimated taxes do so because they have income that isn’t subject to withholding. Examples of this type of income include revenue from freelance work and self-employment as well as pension income.
However, if you have one income source that’s subject to withholding, you can adjust the withholding to account for your income from all sources.
As an example, let’s say you work a 9-to-5 job but also freelance sometimes on nights and weekends. You can increase the withholding amount at your 9-to-5 job to account for both income sources. By using this method, you can avoid having to pay estimated taxes and the penalties that can come with them.
This strategy also works for married couples when one partner has income that is subject to withholding and the other doesn’t. For example, let’s say one partner works on salary as an accountant while the other partner works as a freelance screenwriter. Since the IRS considers the couple’s income jointly for tax filing purposes, the spouse who has the accounting job can increase their withholding to make up the withholding shortfall caused by the screenwriter’s freelance income. This way, both spouses can avoid the headache of estimated taxes and penalties.
S.H. Block Tax Services Can Help You Create Your Annual Tax Plan and Make Estimated Payments
If you owe taxes from previous years, are concerned about how to set up estimated payments, or are dealing with tax liabilities, please contact S.H. Block Tax Services for help. Our attorneys and support staff have decades of experience with tax resolution, and we have earned an A+ rating with the Better Business Bureau.
Estimated taxes. (n.d.). Internal Revenue Service. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes
Internal Revenue Service. (2017, October 31). 10 million taxpayers face an estimated tax penalty each year; act now to reduce or avoid it for 2017 (IR-2017-182) [press release]. Retrieved from https://www.irs.gov/newsroom/10-million-taxpayers-face-an-estimated-tax-penalty-each-year-act-now-to-reduce-or-avoid-it-for-2017-new-web-page-can-help
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