Do You Owe Estimated Taxes?
If you are self-employed or have additional sources of income outside of your regular job, you may fall into the category of Americans who are required to file their federal taxes not just once a year in April, but four times annually. While no one likes having to pay estimated taxes to the IRS, you can make the process easier by setting aside money regularly and keeping detailed records.
The rationale for requiring people to file who do not have all their taxes regularly withheld from their paychecks is simple: The IRS expects Americans, whether employees or independent contractors, to settle their taxes on a pay-as-you-go basis. Failure to pay taxes within a short time after they are owed can result in penalties.
You may need to file estimated taxes if you start your own business or work as a freelancer, or if you sell investments or other property, thus triggering capital gains taxes. Even a sudden change in the types of deductions you are able to take could mean that your usual withholding may no longer be sufficient to cover your tax bill. In short, if you expect to be hit with a large tax bill in April because you have received additional untaxed income or have lost important deductions, you may need to start making estimated tax payments.
The IRS does not usually penalize taxpayers for failure to file estimated taxes if their Federal income tax liability is less than $1,000 or if their withholding covers 90% of the tax bill. Recipients of sudden, one-time windfalls are also seldom required to make estimated payments, provided they pay the taxes due at the end of the year. Interest charges are likely, however, if the amount of underpayment is substantial or if income is received not just once, but on a regular basis.
If you are employed but have other sources of income on which you will owe taxes, you may be able to avoid making estimated tax payments by increasing your withholding on your W-4. Self-employed people must, however, make estimated payments in quarterly installments.
Assuming your income is fairly steady over the course of the year, the IRS expects the four estimated tax payments to be in equal installments. Most taxpayers use the amount of taxes owed in the previous year in order to set their estimated payments for the following year. If, however, your income fluctuates greatly, you are permitted to adjust your payment amounts using an annualized income calculation. Your records should reflect these variations in income, or you will not be permitted to use this method for calculating tax liability.
If the IRS finds you guilty of underpaying your taxes or of failing to pay estimated taxes on time, the agency will levy interest on the amount of the payment owed based on market rates. Thus, penalties will vary depending on the size of the underpayment, prevailing interest rates, and the amount of time that has passed since the payment was due.
Fortunately, filing estimated taxes is relatively easy: Simply fill out Form 1040-ES, Estimated Tax Voucher, enclose a check for the appropriate amount, and send your payment to the IRS. After you have made your first estimated tax payment, the IRS will send you pre-printed forms that you can use in the future. Keep in mind, however, that paying estimated taxes is not a substitute for filing a complete income tax return by April 15 of each year. For more information, consult your tax professional.