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January 12, 2022

Estimated tax payments: How they work and when to pay them

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There are numerous tax types that one might come across, especially if one owns a business. With all the requirements and rules, many people are not sure what estimated tax payments are. Since these taxes are not going anywhere in the foreseeable future, it is worth learning more about how tax requirements apply to your situation.

Estimated tax payments are payments that are done throughout the year towards your final tax bill. There is one catch. We do not know how much our tax bill is going to be until we actually file our taxes, so all payments that we make towards our tax bill are estimates.

These payments exist because the IRS wants to have a way for all taxpayers who do not work for an employer, who can withhold tax for them to still pay their taxes in small installments. In a way, you can think of these payments as deductions that are made on every paycheck. However, instead of the employer taking the responsibility to collect the money, you are now responsible for determining the amount of these taxes and paying them at regular intervals.

Estimated tax payments: How they work and when to pay them

Who pays estimated tax?

This system of estimated tax payments requires that people who work for themselves and business organizations, such as corporations, make regular payments toward their taxes. By self-employed, we mean individuals who have non-employee income and, most likely, will need to pay these taxes.

If you are wondering why only self-employed people need to make these payments, worries aside. Everyone pays these taxes in some way. Those who receive wages or salaries have their employers take out a portion of their earnings towards the taxes every time they get a paycheck, which is typically at least once a month. Self-employed people do not get a paycheck or rather write a paycheck to themselves in some way and take the initiative and pay their estimated taxes.

There is one more condition than just being self-employed. You also need to believe that you will end up owing over one thousand dollars in taxes for the year. Simply put, if your business is relatively profitable, then it is likely that these taxes are a requirement that you need to satisfy.

Even though this is an obligation, it is good for your finances. At the end of the day, we all know that taxes can be very expensive, especially for self-employed people. Ultimately, it means that you are not sucking all the cash out of your business at tax time.

Finally, it is worth noting that some individuals might be exempt from having to make these payments. If you are confident that you will be paying less than one thousand dollars or if your withholding was at least 90% of the actual tax amount you would owe before the government, there is no need to think about estimates.

When is it time to pay?

The IRS breaks down the year into four somewhat equal periods, so the taxpayer ends up paying every quarter. Your first payment would coincide with the well-known tax due date – April 15th. The next date by which you would be required to figure out the amount of income and the tax obligation that relates to that amount of income for that second quarter is June 15th.

They want you to take care of the third quarter earnings obligations, if we can call it that, by September 15th. The fourth date is January 15th. You can remember them as one payment each season and the final payment for the period is done in January of the next year. So, instead of you scrapping to pay the whole bill as one check and the IRS risking that it will not get the money, it promotes good tax planning and ensures an equal cash flow for the governmental activities.

If the individual fails to meet these deadlines and pays the approximate amount of taxes they owe for the income they earned for that period, there are underpayment penalties. Although these are relatively not big, they still further encourage individuals to ensure that they can handle the tax obligations. In addition, most people do not invest all of their money and have some cash just sitting in their checking account and giving an illusion that you have more money than you actually do because some percentage of that money no longer belongs to you. Since many are more likely to spend the money than set it aside for some future obligation, the government might actually be doing a favor to these individuals by creating these estimates.

How much to pay?

How does this whole system work? Individuals take care of the tax liability in a pay-as-you-go kind of way. Either your employer pays on your behalf by taking money from your salary or you should pay it yourself if you have another type of income source. You would pay estimated taxes several times every year.

Once tax returns can be filed, you will know an exact number for your obligation before the government. This is where your estimates come into play. All the checks you sent before are applied to your final tax bill. So, if you owe $18,800 in taxes, but had arrived at $14,300 when you were doing the estimates, then you will just have the difference of $4,500 left to pay.

On the flip side, if you overpay your estimated taxes, then you get a refund. You can also choose to apply the refund amount towards your next tax payment. After all, as long as you keep on earning money, you will have to keep on paying the taxes either in the form of payroll deductions or estimates. So, how do you even figure out how much you should be paying?

If the answers to the previous questions are relatively simple, then estimating how much you would need to pay might be too confusing for some and they simply avoid these payments altogether. Of course, in such cases, it is best to consult with tax professionals and have them either do the calculation for you or show how you would do it. However, we are going to try to help you make these computations yourself.

The first step you can take is to look at your past returns and see how much you earned last year. If you do not believe you will have any big changes, you can pay approximately the same amount. If you project that your earnings will increase or decrease, you would divide that projected amount of income by four, thereby increasing or decreasing your tax payments accordingly. This is tax payment estimation in a nutshell.

To make it possible to arrive at more accurate estimations, you would need to use Form 1040-ES. It is a worksheet provided by the IRS that helps you figure an approximate amount of the future tax liability. Then, you simply divide that number between all the payments and keep a record of the checks you have already sent so far and the dates when you made those payments. You can send your payment online or you can do it the old-fashioned way and write a check to the IRS. Just make sure the form has your name right at the top, so they know who to record the payment for.

What if you don’t pay?

If an individual chooses to forgo the payment or simply doesn’t know about the estimates and fails to pay them, then they will have to pay some penalties. There are penalties for estimating a tax liability that is lower than should be paying, which is essentially an interest charge for not sending the money throughout the year.

There is no specific dollar amount one would need to pay. Instead, it is presented as a percentage (3-5%) of the underpayment amount. It will be calculated when an individual files their income tax return. Taxpayers might also need to pay a late payment penalty, which is 0.5% per month with the limit set at 25%.

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Author: Charles Lutwidge

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