If you are self employed or have a significant income that is not being taxed, you should probably be paying estimated taxes on that income throughout the years in order to avoid paying penalties at tax time.
It’s kind of funny that most people only think about taxes during “tax time.” In our system, it is always “tax time.” Most people do not think about it because most people are employees and taxes are withheld from each paycheck. Almost everybody, at one time or another, even if it was just when you were a kid had a job, and you probably recall filling out that form where you estimated your exemptions. In a way, this is how you pay estimated taxes when you are an employee. You are estimating what you think you will owe. Your employer takes out a percentage of each paycheck. Sometime around April 15th you then can determine your actual tax bill for the year and compare it with what has already been withheld i.e.…what you already paid.
If you paid too much you get a refund. If you did not pay enough, you owe.
Unfortunately, I come across many self-employed people who don’t know they have to pay estimated taxes or they are not quite sure how it works.
Here’s a little summary:
WHO SHOULD PAY ESTIMATED TAXES?
If you are self-employed, have a substantial side income from investments or part-time jobs, or if you have income that is not subject to withholding, you should think about making estimated tax payments.
In order to avoid paying penalties when tax time comes around, you need to make sure that you are estimating your income for the year and meeting one of the IRS’s “Safe Harbor requirements.” Those “Safe Harbors” (this is an IRS term, meaning that if you meet these requirements, you will not have to pay a penalty, even if you owe a substantial amount of taxes).
1). You owe less than $1,000.00 for this year’s taxes.
2). You have withheld an amount equal to 100% of last year’s tax liability.
3). You have withheld 90% of this year’s tax liability.
Number (#1) one above is pretty obvious.
Number (#3) three is also fairly simple. Under the 90% rule, the IRS is basically saying you do not have to be perfect in your estimates, but you have to be within 10%.
For most people the most common Safe Harbor is number (#2) two above. In other words, you are paying estimated taxes equal to the previous year’s tax liability.
Here is an example of how that works:
Let’s say that in 2011 you had a fairly good year and your total tax bill was $20,000.00, which you, of course paid. Now, let’s say in 2012 you have a great year, in fact, your income and your income taxes are twice what they were in 2011. In other words, your ultimate tax liability for 2012 is $40,000.00. If you have paid tax in 2012 totaling $20,000.00 (in other words 100% of the previous year) then at tax time when you owe the additional $20,000.00 there will be no penalty even though you are not within 10% of the actual tax bill.
WHEN ARE ESTIMATED TAX PAYMENTS DUE?
Estimated tax payments are made four times a year on the following dates:
One thing that’s confusing is the payments are not spaced out evenly like most people would assume.
STATE ESTIMATED TAXES AND SELF-EMPLOYMENT TAXES DUE.
You have to make your federal estimated taxes on the dates mentioned above, but you also need to pay your state estimated taxes and your self-employment taxes.
For 2012, you are paying 10.4% for Social Security and 2.9% for Medicare (total 13.3%). Unless it is continued, the self-employment tax will go back up to 15.3% in 2013