Estimating income tax? Tips to improve your skills.

Overhead view of young couple, sitting on couch, and working on a lap top to estimate their income taxes.Image: Overhead view of young couple, sitting on couch, and working on a lap top to estimate their income taxes.

In a Nutshell

You’re supposed to pay most of your federal income taxes throughout the year as you earn or receive income, rather than shelling out a lump sum when you file your tax return. Making estimated tax payments during the tax year might help you avoid penalties — and a big tax bill — come Tax Day.
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You might think about taxes only when it’s time to file, but income taxes can affect your finances throughout the year.

Because the federal income tax system is “pay as you go,” the government expects you to pay taxes periodically, as you earn or receive income. You’re not supposed to wait until the end of the year and then pay your income tax in a lump sum.

If you work for someone else, your employer likely withholds federal taxes from your paycheck, based on the information you enter on your Form W-4. But if you’re self-employed — either full-time or as a second job — you may need to make estimated tax payments on your own throughout the tax year.

Generally, if you expect to owe $1,000 or more in federal taxes when you file your return, you should make estimated tax payments throughout the year. Let’s look at how to calculate how much estimated tax you should pay during the year.

Ways to pay your federal income taxes

Depending on how you receive income, you have multiple ways to pay your taxes.

If you’re employed by someone else, receive a pension or get income from government payments like Social Security, you can have income tax withheld from your income payments.

You can estimate the amount of tax due and make quarterly tax payments four times per year or pay all the tax due on the due date of the first quarterly payment. You can pay any remaining balance owed when you file your tax return. Be aware, though, that if your unpaid balance is too high when you file your return, you may face interest and a tax penalty.

Lisa Cross, a CPA in Reno, Nevada, says that many people have their federal income taxes withheld by their employer, so they’re not required to make quarterly estimated tax payments unless their employer doesn’t withhold enough. But if you’re self-employed or receive income from a rental property, pass-through entity or other sources of income (like a side gig), you’ll have to calculate and make estimated payments throughout the year.

What is the 90% rule for estimated taxes?

Making estimated tax payments can help you avoid penalties. Generally, individuals expecting to owe $1,000 or more in taxes are required to pay at least 90% of what’s due for the current year or 100% of the tax shown on their prior year’s return, whichever is smaller. If you don’t, you may have to pay an underpayment penalty.

You can find out your penalty in one of two ways: Use Form 2210 to calculate your penalty, or allow the IRS to do it for you. If you have the IRS calculate your penalty, it will send you a bill. The quarter for which you underpaid will affect the interest rate used to determine your penalty, which is multiplied by the number of days past the installment due date.

“The penalty is figured separately for each installment due date,” Cross says, “so you may have a penalty for one quarter but not the others.”

But beyond the financial consequences, estimating income taxes is a good idea because it can help you avoid surprises (and a big fat tax bill that you may not be prepared for) at tax time. Plus it can help you avoid significantly overpaying your taxes. Although the IRS typically returns overpayments to taxpayers through tax refunds, remember — getting a big refund means you basically allowed Uncle Sam to use your overpayment interest-free for a year!

How do I estimate my income tax?

A tax professional can help you calculate your estimated income tax, but you can also do the job yourself using IRS Form 1040-ES.

The form includes an estimated tax worksheet that has you enter your estimated adjusted gross income for the year, either the standard deduction or itemized deductions and credits, and then calculate your estimated tax using a tax rate schedule. There’s also a worksheet to help you calculate your self-employment tax deduction, which you may be eligible to take if you’re self-employed. And if you are eligible to take this deduction, you’ll want to include the deduction when calculating your expected adjusted gross income.

It’s a good idea to start with your prior year’s return. Look at the different categories of income you reported on your federal income tax return last year, such as wages, interest and dividends, self-employment income and capital gains. Also take a look at the adjustments to income, or the “above-the-line” deductions that can be used to reduce your adjusted gross income.

What types of income are taxable?

For many people, these numbers are similar from year to year, but if you know of any changes, consider them in your estimate. This will get you to your estimated adjusted gross income (AGI), the starting point of the Form 1040-ES worksheet. From there, you can follow the directions included with the worksheet.

The worksheet will also instruct you to divide your estimated tax in four. These are the quarterly estimated tax payments that are due April 15, June 15 and Sept. 15 of the current tax year, and Jan. 15 of the following year. If the due date falls on a Saturday, Sunday or legal holiday, the payment is due the next business day.

Challenges to estimating income tax

If your income, deductions and tax credits don’t change dramatically from year to year, calculating your estimated income taxes probably isn’t too complicated. But that’s not the case for everyone.

If you’re self-employed in a business where your work and income fluctuate throughout the year, or you have pass-through income from a business like an LLC, partnership or S corporation, it may be difficult to predict your income. In turn, not being able to accurately estimate income can affect your ability to estimate your tax as well.

Another challenge is that the IRS penalty calculation assumes you’ve earned your income evenly throughout the year. Cross says that it’s possible for some taxpayers to receive a large amount of income at year-end that they didn’t necessarily account for in their estimated tax payments.

The IRS offers an annualized income installment method that allows you to calculate your required installments based on your actual income for the quarter. To use this method, you must complete Form 2210, Schedule AI and attach it to your return. This method is also helpful for people whose income is subject to seasonal fluctuations.

Is there an easier option for estimating tax payments?

If you’re worried about underestimating your taxes or just having trouble calculating the amount of your estimated tax payments, Cross says there’s a “safe harbor” option.

“The safe harbor protects taxpayers from penalty if they paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller,” Cross says.

As long as your prior year’s return covered all 12 months of that tax year, paying 100% of the total tax shown on that return should help you avoid a penalty.

What is adjusted gross income?

How can I use this information?

Now that you’ve estimated your income tax liability, what should you do if you’re paying too much or too little?

If you’re paying too much …

You have a couple of options if you’ve over-estimated your tax.

The first is to leave your estimated payments as is. If you’re making quarterly estimated payments and you realize you’re overpaying, when you file your tax return you can have the overpayment applied to the next tax year, thereby reducing the quarterly estimated payments you’ll need to make next year. This is a good idea if you don’t necessarily need the money now and anticipate having higher taxable income next year.

Your other option is to reduce the amount you’ll pay in subsequent estimates. For example, if you’ve already paid your first- and second-quarter estimated payments when you realize you’ve been overpaying, you can recalculate your third- and fourth-quarter payments and pay less toward those installments.

If you’re not paying enough …

On the other hand, if you realize you’ve been paying too little, you’ll want to get caught up as soon as possible. You can make an additional estimated payment at any time during the year — you don’t have to wait for the next quarterly due date.

If your estimated tax payments are withheld from a paycheck and need adjusting, talk to your employer’s payroll department. You can get help completing a new Form W-4 to change your withholding for the rest of the year. You can use the IRS’ online Tax Withholding Estimator to help you understand what adjustments to make, if any, to your W-4 to better estimate your tax.

What’s next?

If an employer doesn’t handle federal income tax withholding on all (or some) of your income, paying estimated taxes can help ensure you’re paying enough during the year to avoid owing a big tax bill or underpayment penalties come tax time. So it’s a good idea to pick a method — either running through the calculation on Form 1040-ES, using the safe-harbor method or using the annualized income installment method — and make estimated quarterly payments.

You’ll find the address for mailing your checks — make sure your payment is postmarked by the quarterly payment due date or you could face a penalty — and the voucher forms included with Form 1040-ES, or you can pay online using IRS Direct Pay or with a debit or credit card.

About the author: Janet Berry-Johnson is a freelance writer with a background in accounting and insurance. She has a bachelor’s degree in accounting from Morrison University. Her writing has appeared in Capitalist Review, Chase News &a… Read more.