The tax system is intended to be a “pay-as-you-go” system, and the only way to prepay taxes is through withholding and estimated taxes. Generally, payroll comes to mind when we think about withholding, but withholding is also available through a variety of other means, including pension income and Social Security payments. However, there are a multitude of income sources that generally do not have withholding, such as self-employment income, interest, dividends, rents, gains from stock sales, alimony etc. Estimated tax payments provide a means of prepaying one’s taxes on these kinds of income.
However, the use of estimated tax vouchers is not limited to taxpayers with income not subject to withholding. A variety of situations might arise that warrant the use of estimated taxes, such as taxpayers who are paid by commissions or who receive bonuses that distort their income. Frequently, a married couple with substantial income may also rely on estimated taxes to supplement its wage withholding.
Whether it’s through payroll withholding, quarterly payments, or a combination, the IRS requires taxpayers to pay a certain amount of income tax during the year. The total amount you’re required to pay depends on your adjusted gross income (AGI) for the previous year. For the current year, your “required annual payment” is the smaller of:
For calendar-year taxpayers paying their estimated taxes in installments, payments are generally due on:
Each of the four installments generally should equal at least 25% of your required annual payment.
If you receive income unevenly (because you have a seasonal business, for example), you may be able to vary your payment amounts and still avoid a penalty by using the “annualized income” method. See the image below for more.
If you do not pay your estimated tax by the due date, the IRS may assess a penalty equal to the product of the IRS interest rate on deficiencies times the amount of the underpayment for the period of the underpayment.*
If you discover that you’ve been underestimating your taxes, you may be able to resolve the problem by requesting an increase in withholding from your or your spouse’s paychecks for the remainder of the year. Or, if you are taking taxable distributions from an individual retirement account, 401(k), or another retirement plan, you could increase the withholding from year-end distributions. With either alternative, the IRS will apply the withheld tax pro-rata over the tax year to reduce prior underpayments of estimated tax.
* You won’t owe an underpayment penalty if the tax shown on your current year return — reduced by withholding taxes paid during the year — is less than $1,000.
There are a number of exceptions to the underpayment of estimated tax penalty, which can help you plan your estimated payments, avoid the penalty and minimize the advance payments.
No Tax Liability In Prior Year—A taxpayer is exempt from the underpayment of estimated tax penalty if they had no tax liability in the prior year and they were a U.S. citizen or resident for the whole year. For this rule to apply, the tax year must have included all 12 months of the year.
De Minimis Exception—Taxpayers can owe up to $1,000 on their tax return without penalty.
Current Year Exception—If a taxpayer’s withholding and estimated tax payments are equal to 90% or more of the current year’s tax liability, then there is no penalty.
Prior Year Exception—The underpayment can also be avoided by prepaying through withholding and estimated tax payments an amount equal to 100% or more of the prior year’s tax liability. Caution: See High Income Taxpayers below.
Prior Year Exception for High Income Taxpayers— For taxpayers with gross incomes (AGI) in excess of $150,000 ($75,000 for married taxpayers filing separately), the prepayments must total 110% of the prior year’s tax. This penalty exception is frequently used by taxpayers as means of determining a safe harbor estimate for the current tax year.
Annualized Income Exception—A complicated exception can help you avoid the underpayment of estimated tax penalty if you have large changes in income, deductions, additional taxes, or credits that require you to start making or adjusting estimated tax payments. The payment amounts will vary based on your income, deductions, additional taxes, and credits for the months ending before each payment due date. As a result, this method may allow you to skip or lower the amount due for one or more payments.
Farmers and Fishermen Exception—If at least two-thirds of the taxpayer’s gross income for the prior year or the current year is from farming or fishing, the taxpayer’s required annual payment is the smaller of: • 66 2/3 % (.6667) of the total tax for the year, or • 100% of the total tax shown on the prior year’s return, provided the prior year was for a full 12 months.
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