For most people, taxes are something that you deal with once a year when you file your income tax return. Depending on the year, you might get a refund or have to pay a little bit. However, that’s only true if most or all of your income is from working as an employee because you don’t have to worry about making estimated tax payments during the year. When you have a decent amount of income from sources that aren’t subject to income tax withholding, you need to worry about paying quarterly taxes or you could face additional interest and penalties from the Internal Revenue Service.
Quarterly tax payments are required if you have sufficient income that isn’t subject to income tax withholding, such as self-employment income, interest and capital gains.
Purpose of Quarterly Payments
Prior to World War II, the IRS didn’t require any income tax withholding or estimated payments. Instead, all taxpayers simply paid the entire amount they owed for the year with their income tax return. However, during World War II, the federal government implemented tax withholding so that income would be withheld during the year. That way, people wouldn’t owe a significant check all at once when they filed their income tax return.
Most people satisfy the requirement to pay income taxes throughout the year through income tax withholding from their employee income. However, not all types of income are subject to income tax withholding. If you have significant income not subject to withholding, you may be required to make estimated tax payments throughout the year.
Income Not Subject to Tax Withholding
Self-employment income isn’t subject to income tax withholding because you don’t have an employer to withhold money from your paycheck. So, while you might feel like you’re making more money when depositing your income into your bank account, remember that a portion of that income needs to be earmarked for taxes.
Interest and capital gains are also generally not subject to income tax withholding. If your only source of interest income is a couple hundred dollars or less from a savings account, it’s unlikely to significantly affect your tax liability, much less require you to make quarterly tax payments. However, if you have significant interest income or expect a large capital gain during the year, such as selling a large stock position or even real estate, you may need to make estimated tax payments.
Timing of Quarterly Payments
Each quarter, you are required to pay a quarter of what you need to pay to meet the safe harbor for avoiding underpayment penalties. For example, if you are making sure you pay 90 percent of your current year’s tax liability, you need to pay 22.5 percent of your tax liability each quarter. If you are relying on paying 100 percent of last year's income, you need to pay 25 percent of your prior year’s tax liability each quarter, unless you’re a higher income taxpayer, in which case you need to pay in at least 110 percent.
For most taxpayers, you’re required to make equal payments for each quarter throughout the year. However, if your income varies radically throughout the year, you could be permitted to make different payments each quarter. For example, say you run a water park and your income is generated almost exclusively in the summer months. You might opt to use the annualized income installment method to figure out how much you need to pay in each quarter. To calculate your quarterly payments under this method, use Schedule AI of Form 2210.
The quarterly payments are due on April 15, June 15, Sept. 15 and Jan. 15. The deadline for each payment is extended until the next business day if the due date falls on a weekend or national holiday. However, if you file your completed income tax return by Jan. 31 of the following year, you can make your last quarterly payment when you file your income tax return. For example, if you’ve made your first three quarterly payments on time, and you will pay the rest of your taxes with your tax return that will be filed prior to Jan. 31 of the following year, you don’t have to make a fourth quarter estimated tax payment.
Penalties for Underpayment of Taxes
If you don’t make the required amount of estimated tax payments, the IRS imposes a penalty on the amounts that you should have paid each quarter, but didn’t. Because the penalties are figured on a quarterly basis, you could owe a penalty if you underpaid in a quarter early in the year, even if you more than made up the difference by paying extra in subsequent quarters. It’s even possible that you could pay so much extra later that you would get a refund overall, but would still owe a penalty for underpayment during an early quarter.
If you know you owe the penalty, but don’t want to figure it for yourself, you can usually ask the IRS to figure the penalty for you and send you a bill. However, in a few circumstances, you will need to calculate the penalty yourself. First, if you are requesting a waiver of part of the penalty, but not all of it, you have to do the math yourself. You also need to calculate the penalty if you are using the annualized income installment method to figure the penalty.
Finally, you have to calculate the penalty yourself if you have income taxes withheld from your paycheck and want to treat those income taxes withheld as being paid on the date it was withheld, rather than as paid over the course of the year. For example, if you worked as an employee for the first half of the year and then were self-employed the second half of the year, you could have a lower penalty if you treat the taxes withheld as being paid in in the first and second quarters of the year. If you want to calculate the penalty yourself, use Form 2210.
Making Estimated Tax Payments
You can make your quarterly estimated payments by mail or online. If you want to mail in your payment, complete Form 1040-ES with your identifying information, your spouse’s identifying information if you’re filing jointly and the amount of your payment. Checks should be made out to the United States Treasury. Each payment voucher in Form 1040-ES is numbered for the quarter of the year that corresponds to each estimated payment.
You can also pay online through the Electronic Federal Tax Payment System, or EFTPS. Once you have created a free online account, you can make your estimated payments through the internet. In addition, you can schedule future estimated tax payments so you won’t accidentally forget to make them.
Minimum Payments to Avoid Penalties
The IRS has several criteria that you can meet to avoid owing penalties for underpaying your estimated tax payments. You only have to meet one of these safe harbors to avoid owing interest and penalties. Of course, you will still have to pay the difference between your estimated tax payments and what you owe, but at least that amount won’t grow any larger because of added tax penalties.
First, you won’t owe any underpayment penalties if the total of your estimated tax payments equals at least 90 percent of your tax liability for the year. For example, say that when you file your tax return your tax liability for the year is $14,000. As long as you’ve made estimated payments totaling $12,600, you won’t be penalized.
Second, you won’t owe any underpayment penalties if your estimated tax payments total at least 100 percent of the tax liability from your prior year’s tax return. However, if your income from the prior year exceeds $150,000, or $75,000 if you are married filing separately, your payments must total 110 percent of the tax liability from the prior year’s return to meet this safe harbor. For example, say your tax liability last year was $12,000. If you file as head of household and your adjusted gross income was $140,000 last year, your quarterly estimated tax payments need to total at least $12,000. But, if your adjusted gross income was $160,000, even if your tax liability was the same because of different deductions and credits, your estimated tax payments would need to total at least $13,200.
Finally, if you will owe less than $1,000 after accounting for tax credits and withholding, you won’t owe any penalties. For example, say you have a limited amount of interest income on top of your salary at the job where you’re paid as an employee. If you only owe $100 in taxes after counting the withholding from your job, you won’t owe any penalties.
Exception for Fishermen and Farmers
If at least two-thirds of your income is from fishing or farming, the threshold for income tax withholding is substantially lower than for most taxpayers. Instead of needing to have at least 90 percent of your current year’s tax liability paid in income tax, you only need to have your estimated tax payments paid during the year for 66.667 percent of what you actually owe. For example, if you meet the income test and you owe $10,000 in taxes, you won’t be penalized as long as you have paid in at least $6,667 in estimated payments during the year.
However, if you file a joint tax return with your spouse, the two-thirds of all income from fishing or farming requirement applies to all of the income – both yours and your spouses. For example, say both you and your spouse make the same amount of money. You earn all of your income from farming and your spouse earns all of his or her income from nonfishing and nonfarming activities. Even though all of your income is from farming, only half of your combined income is from farming, so you don’t qualify for the lower tax withholding threshold.
Penalty Waivers from the IRS
The IRS does have the discretion to waive the penalties for underpayment of your estimated taxes during the year in certain circumstances. First, if you missed a payment because of a casualty event or disaster, and the IRS agrees that it would be unfair to assess the penalty, it can be waived. Casualty events include natural disasters, fires and theft. For example, if your town was hit by a hurricane during the week your quarterly payment was due and you weren’t able to mail in a check or pay online, the IRS can agree to waive the penalty.
The IRS also has discretion to waive the penalty if you retired and are at least 62-years-old or became disabled during the current year or the year prior to the year you should have made the estimated tax payments. The missed payment must be due to reasonable cause and not willful neglect. For example, if you retire and go from having income taxes withheld from your paycheck to selling some of your stocks in a brokerage account and weren’t aware of the need to make estimated tax payments, the IRS can waive the penalty.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."