It often seems that employees get the better part of the deal when it comes to paying taxes. Some money is withheld from their check each pay period, then all they have to do is file by the IRS tax deadline to get a tax refund. But freelancers and small business owners usually don’t have a human resources department pulling tax money out of their paychecks. Small business owners have to pay estimated taxes four times a year.
The U.S. has a pay-as-you-go taxation system. Just as income tax is withheld from employees every pay period and sent to the IRS, the estimated tax paid quarterly helps the government maintain a reliable schedule of income, and it protects you from having to cough up all the dough at once. While it’s a little extra work, filing your estimated tax payments each quarter helps you stay on top of your taxes.
What Are Estimated Tax Payments?
When you are an employee, it is your employer’s responsibility to withhold federal, state, and local (if any) income taxes and send that withholding to the IRS (and state and locality). Those payments to the IRS are your prepayments on your expected tax liability when you file your tax return. Your Form W-2 has the withholding information for the year.
When you file, if you prepaid more than you owe, you get some back; if you prepaid too little, you get to make up the difference and pay more. Your withholding is based on the most recent Form W-4 you filed with your employer’s HR department. If you’re in business for yourself, however, you need to be your own HR department and regularly send the IRS money.
Since, as a self-employed person, no income tax withholding is being done, you may need to make estimated payments. Paying estimated taxes requires you to estimate in advance how much you expect to owe the government in taxes for the current tax year. You then send in four quarterly payments that together total that amount. The due dates for quarterly estimated payments fall near the middle of the months of April, June, September, and January. For the 2018 tax year, estimated tax payments are due:
- April 17, 2018
- June 15, 2018
- September 17, 2018
- January 15, 2019
If you don’t make quarterly estimated tax payments and are required to, the IRS will hit you with a penalty for failure to pay estimated taxes. To avoid penalties, you need to know if you’re responsible for estimated taxes, how to determine the amount, and how to send your payments efficiently.
Do You Need to Pay Estimated Taxes?
If you fall into one of these two groups, you most likely need to make estimated tax payments:
1. Self-Employed Full-Time Workers and Small Business Owners
If you file as a sole proprietor, S-Corporation shareholder, partner, self-employed, or single-member LLC, it’s very likely you need to pay estimated taxes on a regular basis.
2. Freelancers With a Regular Job That Withholds Taxes
If you have a full-time job with tax withholding and also work on the side and either receive a 1099-MISC or have clients or customers who pay you directly, you need to determine how much of your income is untaxed. If your freelance work constitutes a significant portion of your income, you should probably pay estimated taxes. A good rule of thumb is that if your side income is less than 10% of your gross income (earnings before taxes), you’re probably not going to need to make estimated tax payments.
How to Estimate Your Taxes
If you use tax-preparation software, and you owe $1,000 or more, the software will ordinarily figure estimated tax payments and generate four Form 1040-ES vouchers for you to use to mail estimated payments for the coming year. Otherwise, follow the IRS instructions for Form 1040-ES to determine how much you should pay in estimated taxes and to create vouchers if you choose to send those payments in by mail.
If you receive your self-employment income irregularly through the year, you may be able to pay different amounts throughout the year to more closely match your income. To avoid penalties, be sure to pay the minimum amount required for the quarter by the quarter’s due date. You can also make more than four estimated tax payments during the year. You can get a 1040-ES payment voucher to fill out online to send with your extra payment(s).
Freelancers and independent contractors are frequently surprised at the large tax bill they face when they have a nice net profit for the year. This is because they not only pay income tax on the profit, but they have to pay self-employment (SE) tax as well. Self-employment tax is part of your overall tax liability, and is one thing that makes estimating total tax liability difficult.
There is, however, a formula you can use to figure your self-employment tax. Take your net profit from Schedule C and multiply it by two numbers: 92.35% and 15.3%. The result is your SE tax. For example, if your net profit is $10,000, your SE tax is calculated as follows: $10,000 x .9235 x .153 = $1,413.
Half of this amount ($707) reduces your AGI and lowers your income tax by a small amount (depending on your tax bracket). But if you calculate your estimated taxes using the full amount of your SE tax, you will be sure to pay enough. Of course, tax software takes SE tax into consideration when it generates your 1040-ES vouchers.
How to Pay
You have a range of options for submitting payment. Besides mailing your payment, you can pay online by debit or credit card (there is a convenience fee) or by using the EFTPS system (no fee, but you have to enroll). You can pay by ACH transfer from your checking account using IRS Direct Pay (free), or pay by phone using the EFTPS system.
Registering with EFTPS isn’t complicated. You just need a bank account, Social Security Number or employer identification number, and a mailing address. You must use the mailing address that the IRS has on file, and they’ll mail you a PIN in about a week. Using that PIN, you can get into their website anytime to schedule a payment. Once you set up your bank account with EFTPS, you can schedule withdrawals.
Most tax software packages have the option to schedule estimated tax payments for the coming year by direct debit. You can schedule the amount of the payment and the date the payment will be deducted from your account.
When to Pay
You should pay taxes on the earnings from each quarter after the quarter has ended. However, the quarters aren’t equal – the second quarter is two months, and the fourth quarter is four months.
Estimated tax payment deadlines are below:
- First Quarter (January 1 to March 31): Estimated taxes due April 17, 2018
- Second Quarter (April 1 to May 31): Estimated taxes due June 15, 2018
- Third Quarter (June 1 to August 31): Estimated taxes due September 17, 2018
- Fourth Quarter (September 1 to December 31): Estimated taxes due January 15, 2019
Escape the Underpayment Penalty
You may be liable for an underpayment penalty if you pay less than 100% of your tax liability by the tax filing deadline. You can avoid the penalty if you meet one of the exceptions below:
- You’ve already paid (through estimated tax payments or withholding) the lesser of the amount you paid in taxes last year or 90% of what you owe this year. The one exception is that you must pay 110% of last year’s tax liability if your gross income was at least $150,000.
- Your tax liability is $1,000 or less for the entire year.
- You had no tax liability last year.
- Your total withholding for the year (plus estimated payments you made) is within $1,000 of your total tax liability on the deadline.
If you’re a “better safe than sorry” taxpayer, and you’re concerned about underpayment, you can either increase your federal income tax withholding allowances if you have a full-time job, or overestimate your quarterly tax payments if you’re self-employed. It may feel good at tax time to be getting a refund – just remember that the money you are getting back is money you loaned the government at no interest.
The IRS has a new initiative called “Pay As You Go So You Won’t Owe” to educate the more than 10 million taxpayers they anticipate will be issued a penalty for not making estimated tax payments. They recommend adjusting your withholding or making estimated tax payments as a way to avoid the penalty.
Think of estimated tax payments as a budgeting tool. It not only makes you think about your income and expenses a year in advance (which is good for planning purposes), but it helps you budget your tax payments to avoid a penalty. Budgeting your payments is one strategy to help manage your cash flow.
Are you making quarterly estimated tax payments? What tools do you use to estimate your tax due and make sure you don’t miss deadlines?