Tax Planning and Compliance
Estimated Tax Payments
Some individuals have to pay estimated taxes or face a penalty in the form of interest (presently 3.5%) on the amount underpaid. Self-employed persons, retirees and nonworking individuals most often pay estimated tax to avoid the penalty. However, an employee has to pay them if the amount of tax withheld from wages is not sufficient to cover the tax on other income.
The trick with estimated taxes is to pay a sufficient amount of estimated tax to avoid a penalty but not to overpay. That’s because while the IRS will refund the overpayment when you file your return, it won’t pay you interest on it. Individual estimated tax payments must be made in four installments. Payments generally are due on April 15, June 15, September 15, and January 15 of the following year.
Usually, there is no penalty if your estimated tax payments plus other tax payments, such as wage withholding, equal either 100 percent of your prior year tax or 90 percent of your current year tax. However, if your adjusted gross income for your prior year exceeded $150,000, you must pay either 110 percent of the prior year tax or 90 percent of the current year tax.
Estimated tax is not limited to income tax. In figuring your installments, you must also take into account other taxes such as the alternative minimum tax, penalties for early withdrawals from an IRA or other retirement plan, and any self-employment tax.
What if you realize you have miscalculated before the year end and paid in too little tax? An employee may be able to avoid the penalty by getting the employer to increase withholding in an amount needed to cover the shortfall. The IRS will treat the withheld tax as being paid proportionately over the course of the year, even though a greater amount was withheld at year-end. The proportionate treatment could prevent penalties on installments paid earlier in the year.
What else can you do? If you receive income unevenly over the course of the year, you may benefit from using the annualized income installment method of paying estimated tax. Under this method, your adjusted gross income, self-employment income and alternative minimum taxable income at the end of each quarterly tax payment period are projected forward for the entire year. Estimated tax is paid based on these annualized amounts if the payment is lower than the regular estimated payment. Any decrease in the amount of an estimated tax payment caused by using the annualized installment method must be added back to the next regular estimated tax payment.
As you can see from this overview, figuring out estimated taxes can be rather complex. The only way to be sure you are planning your payments properly is to make quarterly tax planning projections.