Taxpayers are required to make estimated tax payments to avoid owing penalties for underpayment of taxes. Uncle Sam and states want taxpayers to pay in taxes throughout the year on their incomes and enforce compliance of making estimated tax payments by imposing penalties for underpaying taxes throughout the year. This post provides helpful information for taxpayers to minimize underpayment penalties.
Business Owners
New business owners are often surprised to learn that they are required to make quarterly estimated tax payments to avoid penalties. A major difference between being employed and being self-employed is no one withholds income tax from your income when you are self-employed. In fact, your income for the year is TBD until the end of the year, as you could incur additional expenses in your business between now and year-end that would reduce your income. However, this does not mean you won’t owe penalties for underpaying your taxes.
If you have a loss from your business you may not owe any penalties. You’re only required to make estimated tax payments when you owe taxes (generally meaning have taxable income).
Estimated tax payments are also required for self-employment taxes (Social Security and Medicare taxes) due on net income from businesses. Self-employment taxes are included with your federal tax liability and are included in estimated tax payments. No separate reporting is required for self-employment taxes when it comes to estimated tax payments. Simply combine the amount of your payment.
Employees, Retirees, & Other Taxpayers
Underpayment penalties don’t just apply to business owners, they apply to all taxpayers. It’s easy to overlook penalties included in your tax liability. IRS letters and tax returns are difficult for most taxpayers to understand. I had a client that wrote a check for over $5k of federal underpayment penalties for a single year (before becoming my office’s client) tell me they have never owed underpayment penalties, I later came across the check in their business’ QuickBooks file and brought it to their attention.
Safe Harbor
Taxpayers can avoid owing penalties by making the minimum requirements payments needed pay in a percentage of their prior year tax liability during the current year. Single taxpayers that had less than $75k of taxable income in the prior year (and joint taxpayers that had less than $150k of taxable income in the prior year) can meet safe harbor by paying 100% of their prior year tax liability during the current year. Taxpayers with taxable incomes above these thresholds are required to pay 110% of their prior year tax liability to reach safe harbor.
For example, if your filing status is single and your 2019 taxable income was $70k, you can avoid owing penalties for underpayment of estimated taxes by paying in 100% of your 2019 tax liability throughout 2020. Any additional tax is due with your 2020 tax return by April 15, 2021.
Safe harbor offers a guide taxpayers can use to avoid owing penalties for underpayment of estimated taxes. Additionally, taxpayers that expect to have significantly more income in the current year can benefit from the time value of money by holding on to any additional required tax due until the due date of their tax return (before extensions).
90% Rule
If you pay 90% of your total tax liability during the current year (by the required due dates), you will not owe penalties for underpayment of estimated taxes. The remaining tax is due with your return by April 15th.
Federal Income Tax Withheld
By default, federal income tax withheld (including tax withheld on wages and retirement plan distributions) is assumed to be withheld evenly throughout the year. Taxpayers can use this to their advantage by recognizing a shortfall of withholding or income tax payments and increasing federal income tax withheld from their income by year-end to compensate for the lack of withholding and estimated tax payments earlier in the year.
Annualized Installment Method
By default, your income is assumed to be earned evenly throughout the year, however; if a large portion of your income is earned later in the year, you may benefit from electing to use the annualized installment method by reporting how much income is earned in each quarter in order to minimize penalties.
Due Dates:
April 15th – for income earned between January and March
June 15th – for income earned between April and May
September 15th – for income earned between June and August
January 15th – for income earned between September and December (of the prior year)
How to Make Estimated Tax Payments
The IRS allows you to schedule estimated tax payments directly on their website. The IRS offers a payment feature called IRS Direct Pay that allows individual taxpayers to schedule electronic tax payments from their bank accounts. An added benefit is you receive a payment confirmation as proof of payment.
Here are instructions on making 2020 personal estimated tax payments using IRS Direct Pay:
Go to https://www.irs.gov/payments/direct-pay and click “Make a Payment.” On the next page, select “Estimated Tax” as the “Reason for Payment”, select “1040ES” as the form to apply the payment to, and “2020” as the “Tax Period for Payment.” On the next page, it will ask questions to verify who you are in order to apply the payment to your account correctly. You can select “2018” or “2019” as the prior tax year to verify information from.
Contact me to discuss this topic in further detail
Please note: the information on this website is intended to provide general advice to start the discussion with your tax professional. The information on this website may not apply to your specific situation. Only an experienced professional with the details of your specific situation can advise you on making the best decision. Contact me or your tax professional to discuss the information on this site to make an informed decision.