Estimated Taxes and Avoiding Underpayment Penalties
Today is not only the deadline for filing taxes, it’s also the due date for the first quarterly estimated tax payment of 2007. Technically, federal income tax is a pay-as-you-go tax, meaning that you’re supposed to pay into the system as you receive income during the year. For a regular job, this usually isn’t a problem, as your tax withholding will take care of it. But in the case of self-employment income (or any other income that isn’t subject to withholding) you’ll need to file estimated taxes.
Estimated taxes can be figured using Form 1040-ES, and you can either pay a lump sum up front, or you can make quarterly payments (see: Important 2007 Tax Filing Deadlines for due dates). The problem here is that, if you don’t pay enough in over the course of the year, the IRS can penalize you.
In general terms, you’ll be subject to an underpayment penalty unless the total of your annual withholding and credits exceeds:
(1) 90% of the total tax owed for the year in question, or
(2) 100% of the tax shown on your previous year’s tax return
That being said, there are circumstances under which #2 becomes 110% of the tax shown on your previous year’s return (see Form 1040-ES for details).
If you’re not going to hit these thresholds via withholding, then you’ll need to make estimated tax payments. Keep in mind that estimated taxes can be paid all at once, or you can choose to file quarterly. But if you file quarterly, the IRS will expect to see approximately equal payments across quarters (although there are exceptions if your income is uneven). Keep in mind that you you don’t necessarily have to pre-pay your full tax bill. Rather, hit the thresholds above and you should be in the clear. Of course, you’ll have to pay the balance due when it comes time to file your taxes next year.
Published on April 17th, 2007 - 5 Comments
Filed under: Self Employment, Taxes
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There’s plenty of opportunity for arbitraging the difference between the required payments and the total tax.
For 2006, I owed $3,700 federal, with no penalties/interest (I put the check in the mail today). For 2007, I will owe $12,000, with no penalties/interest.
For some people, though, the ’sticker shock’ of making a huge payment on April 15th is too much to bear, and they prefer to have more withheld. For me, I’d prefer to have the $12,000 earning interest for me, not Uncle Sam.
Comment by CPA1298 — Apr 17th 2007 @ 2:33 pmI think it is worth noting that if you overpay your pre-determined taxes at the end of the year you can get a decent sized refund.
I did that with overpaying by nearly $4,000 and got a huge kickback check after filing my taxes. What sucked though was that I was paying money out throughout the year that I could have grown other ways. bad beat!
Comment by Blain Reinkensmeyer — Apr 17th 2007 @ 6:23 pmYeah, I’m not sure how that’s a good thing. I mean, unexpected tax savings that allow for a refund is great, but intentionally overpaying just to get a ‘windfall’ is something else entirely.
So– sorry this question is a bit dense, but I want to make sure i am doing this right.
“In general terms, you’ll be subject to an underpayment penalty unless the total of your annual withholding and credits exceeds:
(1) 90% of the total tax owed for the year in question, or
(2) 100% of the tax shown on your previous year’s tax return”
As an example of #2:
John withholds only $400 in 2008.
John makes $50K in 2008 and owes much more in taxes, which he did not prepay.
But in his 2007 Tax Return he owed only $400 for the year (since that year his income was low).
a) Is it correct that John will not be penalized in 2008 for not paying estimated taxes?
b) Can John prepay some estimated taxes anyway, even though he was not required to and did not make all quarterly payments?
Thanks!
Comment by friendofjohn — Aug 23rd 2008 @ 2:25 amCorrect, you only need to withhold as much this year as your total tax bill from last year. That’s for federal. Different states might be different. So if you make a lot more this year than last year, you can set extra aside in an high yield savings account and then just make a big payment when you file your taxes. As for (b), I believe you are correct there, as well. It sounds like you’re talking about paying more than the minimum required to avoid a penalty, so there shouldn’t be any problems.