If you have your own business or are otherwise self-employed (as a freelancer or independent contractor, for example), you need to make estimated tax payments to the IRS throughout the year in order to avoid paying interest and penalties on top of your taxes. But who is required to file estimated taxes, and how do you go about it?
What are Estimated Taxes
Estimated taxes are the taxes on income that is not subject to withholding. Those in the U.S. who are employed by others usually have federal income taxes (and state taxes, where applicable) withheld from their check by their employer. The employer then forwards the amounts withheld along with the employer's contribution to the Internal Revenue Service (IRS).
However, those who are self-employed, including those who work as independent contractors or freelancers rarely have income taxes withheld from their payments. Other income may also not be subject to withholding including, but not limited to:
- Interest and dividend income
- Alimony payments
- Rental income
- Gains from the sale of assets, and certain Social Security and unemployment benefits
Additional Taxes for the Self-Employed
In addition to income tax, those who are self-employed are also required to submit estimated tax payments for their SE (Self Employment) tax.
Self-employment tax (SE tax) is a Social Security and Medicare tax. The current self-employment tax rate is 15.3% and consists of 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare. This tax is essentially the same as the Social Security and Medicare taxes withheld by most employers, except that employers are required to pay half the tax, whereas those who are self-employed pay both halves. The Social Security portion is subject to maximum income limitations ($106,800 in 2010); the Medicare part is not.
Who Must Pay Estimated Taxes
You must pay estimated tax for the current tax year if both of the following apply:
- You expect to owe at least $1,000 in tax for the current tax year after subtracting any withholding and refundable credits.
- Your withholding and credits are expected to be less than the smaller of: a) 90% of the tax you expect to owe, or b) 100% of your total tax liability shown on the prior year's return.
Sole proprietors, partners, and S corporation shareholders usually have to make estimated tax payments if they expect to owe tax of $1,000 or more when they file their federal tax returns, and C corporations if they expect to owe tax of $500 or more when the return is filed.
You do not have to pay estimated tax for the current tax year if you meet all three of the following conditions.
- You were not required to pay taxes in the previous tax year
- You were a US citizen or resident for all of the previous tax year
- Your previous tax year covered an entire 12 month period
When Estimated Taxes are Due
Estimated tax payments are due 4 times each year according to this schedule (or the next business day if the due date is a legal holiday or weekend day):
- April 15th - for earnings from January 1 through March 31.
- June 15th - for earnings from April 1 through May 31.
- September 15th - for earnings from June 1 through August 31.
- January 15th - for earnings from September 1 through December 31.
If you don' pay enough tax by the due date of each of the payment periods, you may be charged a penalty even if you are due a refund when you file your income tax return. You can also decide to pay your entire estimated tax liability for the year by April 15th (although I'm not sure why you would want to do that).
If you file Form 1040 or Form 1040A by February 1 (or the next business day) and pay any remaining taxes due, you don't need to make the payment due on January 15. For most who are unemployed, this is nearly impossible since 1099 forms often arrive late.
If you are a fiscal year taxpayer (your tax year does not follow the standard calendar year), your payment due dates are:
- The 15th day of the 4th month of your fiscal year,
- The 15th day of the 6th month of your fiscal year,
- The 15th day of the 9th month of your fiscal year, and
- The 15th day of the 1st month after the end of your fiscal year.
Like calendar year taxpayers, you do not have to make the last payment if you file your income tax return by the last day of the first month after the end of your fiscal year and pay all the tax you owe with your return.
Calculating Your Estimated Tax Liability
Tax software programs will help you calculate your estimated tax liability. Additionally, the IRS provides instructions and a worksheet for calculating your estimated tax payments (use the Pub. 505 link below), which are filed with IRS Form 1040-ES. You should keep the worksheet for your records and keep records of the dates on which you make your estimated tax payments throughout the year. This information is critical for completing next year's return and you will need it for calculating any interest or penalties resulting from underestimating your tax liability.
How to Pay Your Estimated Taxes
The IRS offers five ways to pay your estimated tax:
- Credit an overpayment from the prior year's return to the current year's estimated tax.
- Send in your payment (check or money order) with the corresponding payment voucher from Form 1040-ES.
- Pay electronically using the Electronic Federal Tax Payment System (EFTPS). You need to enroll for this service in order to use it and you can set up one-time or recurring payments up to a year in advance. Enroll online at www.eftps.gov. You can also modify or cancel payments as late as two days before they are paid.
- Pay by electronic funds withdrawal. You set this up when you electronically file Form 1040 or Form 1040A, at which time you can arrange to withdraw funds electronically for up to 4 estimated tax payments that follow. Tax software, and tax preparers can set this up for you.
- Pay by credit or debit card using a pay-by-phone system or the Internet through one of only 3 IRS-authorized card processors. You will be charged a processing fee, the amount of which will be provided to you at the time of payment.
Each of these payment methods are explained in detail on the IRS website and in IRS Publication 505 - Tax Withholding and Estimated Tax.