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When income is not subject to withholding, you typically need to pay estimated taxes. Income not subject to withholding includes, but is not limited to, income from self-employment, interest, alimony, dividends, rent, prizes, and from the sale of assets; basically it is income from sources that pay you without first taking taxes out.
Even if you are an employee and taxes are withheld from your income, you may still need to pay estimated taxes. This is true in case of employees who are also landlords receiving income from rent, employees who receive interest from investments, and so on. When calculating your estimated tax for the year, you need to include not only income tax, but also other taxes such as self-employment tax, if applicable.
Estimated tax payments are sometimes called quarterly tax payments, because the IRS divides the year into four payment periods and requires taxpayers to make a payment at the end of each quarter. Taxpayers can make weekly, bi-weekly or monthly payments if they choose, as long as there is enough paid by the end of the quarter.
Calculating Estimated Tax
If you receive all or the majority of your income from self-employment, rent, alimony, etc., then you need to establish how much tax you are required to pay from your income source. If income is being received from multiple sources, it is advisable to use the services of a professional tax preparer to determine your tax liability, and the specific deductions and credits that you can claim to lower your tax bill.
When calculating your estimated tax payments, it is helpful to work off your previous year's return, if possible. Otherwise, you will need to estimate the amount of income you expect to earn for the year and pay accordingly. Sole proprietors, partners, s-corporation shareholders and self-employed individuals should use Form 1040-ES to calculate and pay their estimated taxes. Those filing as a corporation should use Form 1120-W to calculate and pay estimated taxes.
Payment Threshold for Estimated Tax
If you are a sole proprietor, partner, s-corporation shareholder, and/or self-employed, you need to make estimated tax payments if you owe $1,000 or more in taxes for the year.
If you are filing as a corporation, the minimum threshold is $500. If you owe $500 or more, then you need to pay estimated tax in the income.
If you are an employee receiving income from other sources, you can ask your employer to withhold more from your pay to cover for the additional taxes. Use the special line on Form W-4 where you can enter additional amount of taxes that you want to get withheld. It is a good way to save yourself from the bother of filing estimated taxes, especially if your income from other sources is minimal.
When You Don't Need to Pay Estimated Tax
You are not required to pay estimated tax for a year if you fulfil all of the following restrictions:
- You had no tax liability in the previous year, and
- You were a U.S. citizen or resident for the entire year, and
- Your previous tax year covered a 12 month period.
These rules do not apply to fisherman and farmers, as their estimated tax requirements are different.
Penalty for Underpayment of Estimated Tax
If you fail to pay enough tax during the year, the IRS will charge a penalty for the underpayment of estimated tax. As there is a likelihood for mistakes when estimating the amount of taxes to be paid, the IRS does not penalize taxpayers who pay at least 90% of the tax for the current year or who pay 100% of the tax shown on their previous year's tax return, whichever is smaller. You can also avoid the penalty if you owe the IRS less than $1,000 after withholdings and credits.
The IRS waives the penalty for underpayment if:
- Taxes were not paid due to a casualty, disaster, death or other circumstances beyond the control of the taxpayer, or
- The taxpayer retired (after reaching age 62) or became disabled during the tax year for which estimated payments were not paid or in the preceding tax year.
The IRS usually accepts request for a waiver of penalty if the underpayment or non-payment was because of a "reasonable cause" and not intentional neglect.