One question that I get a lot from clients relates to confusion regarding estimated taxes. I get this question most often from taxpayers who have been employees for most of their careers and for whatever reason find themselves self-employed, either full-time or by just having a side gig.
Generally the questions fall around: “Do I have to pay quarterly estimates?”, “When are they due?”, and “How much do I have to pay?”
I’m going to lay down a “brief” primer on estimated taxes and why, primarily self-employed people, have to pay them.
The Feds require all taxpayers to pay in both Income Tax and FICA taxes throughout the year as you earn your income. Taxpayers who are classified as employees (those that work for “the man”) have both of these taxes withheld by their employer before they ever get paid .
This is a pretty crazy development that we accept as the governed in that you agree to work with an employer for money and before you even receive it, the government carves out their share first. I don’t want to stand too long on this soap box. So, employees have their taxes withheld and remitted to the government by their employer every pay period, generally.
For those who are self-employed, the government does not yet have a practical way to get their hands on the funds nor appropriately assess how much to withhold since self-employed taxpayers pay tax on their net income (income after expenses) rather than their gross income (cash that comes in the door). Since self-employed taxpayers don’t have withholdings they are required to make tax payments every quarter for what they expect to owe. This is how we get the term “Quarterly Estimated Tax Payments”.
Taxpayers are required to reasonably estimate how much tax they think they will owe when filing a tax return after the year closes. Again this process is more difficult for a self-employed person rather than the employee. A self-employed taxpayer may know how much gross income they have in a quarter, but the net income may be completely different depending on what expenses they incurred to generate that income. These expenses reduce the amount of income they are required to pay tax on. FICA taxes complicate matters further. For employees, the FICA tax responsibility is shared between the employee and the employer, with each group remitting half of the tax. In reality, the employee bares the cost of the full tax, they just don’t feel it. Therefore it is accepted. One half of the tax is paid through direct withholding of the employee’s wages, the other half is indirectly paid by the employee in the form of suppressed gross wages that they never see because it is a cost of employment to the company. This unseen half is remitted to the Feds by the employer. For the self-employed, they are directly responsible for both the employee and employer portions and this is reported to the IRS annually as a part of their income tax return.
Since knowing what you are going to earn on a net basis may be difficult to predict, the IRS “offers” what are referred to as “safe harbor” calculations whereby, if you pay these safe harbors amounts, you will not be assessed any penalties for the underpayment of tax, even if you owe when you file your tax return.
The most commonly used safe harbor is related to the prior year tax. If your adjusted gross income (a tax return calculation) is less than $150,000, then as long as your estimated tax payments total at least 100% of the tax owed in the prior year, you will not be assessed a penalty for underpayment of tax, even if you owe $1,000,000. If your AGI for the prior year is over $150,000, then you have to pay 110% of the prior year tax to be eligible for this safe harbor.
The other safe harbor is much more subjective. You have to pay in 90% of the tax for the current year to avoid penalties for underpayment of tax.
So, when are your quarterly taxes due?
Payments are due to be sent by calendar year taxpayers (most everyone) on the following schedule:
April 15th
June 15th
September 15th
January 15th (following year)
These dates are adjusted forward if they happen to fall on a holiday or weekend.
Underpayment penalties are assessed on a daily basis, for each day and amount of tax that you are underpaid. When you file your return, the IRS generally assumes that you earned your income steadily throughout the year. If you have a highly seasonal business where the bulk of your earnings occurs in the 3rd or 4th quarter, you can fill out the schedule as part of the Form 2210 for calculating underpayment penalties. This will tell the IRS, “Hey, I didn’t earn my income evenly and I’m not underpaid.”
Still with me?
I hope this helps you keep up with your tax payments when you start your own business or even a side hustle. When you want more info on tax impacts of side hustles check out my prior post HERE
Leave your tax questions or a personal story about estimated taxes down in the comments below. We will what kind of future post I can cook to answer them. Thanks for reading!