Post by: Kelly Lopez

As tax season approaches, we wanted to give you a friendly reminder that fourth quarter federal estimated tax payments are coming up soon.  Thus, if you have not done so yet, make sure you mail out your payments on or before the 17^th January.  Most states follow a similar concept, each having their own rules so our discussion will focus on federal payments.

What are estimated taxes anyway?

While you only file your tax return once a year, the IRS requires taxpayers you to pay your taxes periodically during the year in order to avoid penalties. If you have wages, this gets done by your employer through your withholding. However, people who have other sources of income (interest, dividends, capital gains, etc.), are self-employed, or both are required to make estimated tax payments every quarter on April 15^th, June 15^th, September 15^th and January 15^th. If any of these dates falls on a weekend or federal holiday, the payment is due the next business day. Form 1040-ES is used to submit the payments.

How are estimates calculated?

There two ways to calculate your estimates in any given year. The first one is the “Safe Harbor Method.” Under this method, you would use a percentage of your prior year tax liability to calculate your total payments. If your adjusted gross income is $150,000 or less, the safe harbor is 100% of your prior year’s tax. However, if your prior year adjusted gross income is more than $150,000, you would have to pay 110% of the prior year tax in order to avoid penalties.  Once you’ve determined your total safe harbor number, you have to divide it by four and that amount is what must be paid per quarter.  Missing quarterly payments will result in underpayment penalties, so make your payments on or before the days stated earlier. Keep in mind that while timely payments under this method would shield you from underpayment penalties regardless of your current year tax, you would still need to make any additional payments by April 15^th, either with your tax return, or with your application to extend your tax return.

The second option to calculate your total estimates is by paying 90% of your estimated current year tax. The risk here is that if your actual tax ends up being higher than you expected, you are likely to incur underpayment penalties. Generally, when you use this method you will also want to make four equal payments during the year on the dates referenced earlier, particularly, if you expect your income stream to be even during the year. However, if you receive income unevenly during the year, you may be able to adjust the amounts to match your quarterly income by using the annualized installment method. The concept here is the same – 90% of your expected current year tax—but the timing is different. For example, say you expect your income to be low during the first three quarters of the year, but expect to sell an investment property that will generate a large gain in December. For the first three quarters of the year you would use the lower income amounts to determine your estimate, but would factor in and pay the tax on that large gain during the 4^th quarter, which is when it actually happened. Alternatively, if the gain takes place at the beginning of the year, your first payment will be larger as it would reflect the gain.

The decision of what method is better will depend on a taxpayer’s situation in a given year. Thus, we encourage you to consult your tax advisor to determine what works best for your particular set of circumstances.

For more information, please see the instructions for Form 1040-ES. These instructions, along with additional material on this subject which can be found at: https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes