All About Estimated Taxes: Why and When to Pay, Penalties for Not Paying
Making “quarterly” estimated tax payments…it’s one of the burdens of owning a small business or being self-employed.
As an employee, you collected a steady paycheck and had your taxes withheld from each one.
Ideally, you got to the end of each year, had enough withheld and didn’t owe any more money to the government when you filed your personal income tax return.
As a small business owner, things have changed.
You are supposed to calculate and pay in your estimated taxes every few months.
Even if you are organized as an S-Corporation and pay yourself a small wage with tax withholdings, you are still supposed to make estimated tax payments for any profits those withholdings don’t cover.
And while you’ll often hear these payments referred to as quarterly estimated tax payments, they’re not actually made quarterly.
Keep reading and I will break it all down for you.
You’ll learn why you are supposed to make estimated tax payments, how much you are supposed to pay, when you should make them, what happens if you don’t and more.
Note: This post only applies to Federal income taxes. If your state imposes an income tax or other business taxes, the rules may be similar, but you should refer to your state’s Department of Revenue or discuss your state’s requirements with your personal tax advisor.
Why Pay Estimated Taxes
The government wants you to pay your taxes throughout the year so that they don’t have to wait until the following year to square up.
It’s all about the time value of money.
A dollar today is worth more than a dollar tomorrow.
So, the sooner the government can collect your tax payments, the sooner they can invest that money into running the country.
For Federal tax purposes, if you expect to owe more than $1,000 in tax at the end of the year, you are supposed to pay that tax in advance by making estimated tax payments.
How Much Should You Pay?
If you expect to owe more than $1,000 in Federal taxes, the IRS wants you to make estimated tax payments.
But how much should you pay?
To avoid being assessed any penalties or interest by the IRS, you can pay estimated taxes based on one of two amounts.
The more easily determinable amount is to base your estimated tax payments on your prior tax liability.
You can pay in estimates evenly throughout the year to ensure you cover 100% of your prior year tax liability (110% for higher income taxpayers).
If you owe more for the current year, you simply pay it before April 15 of the following year, whether that is when you file your return or request an extension.
Doing this will avoid any interest or penalty.
Jim and Pam are married.
Jim has a job and gets a W-2.
Pam owns a small business.
In 2016, they had $15,000 in tax liability.
In 2017, Jim expects to have $10,000 in Federal income tax withheld from his paychecks.
To avoid interest and penalties, $5,000 can be paid evenly throughout the year in the form of estimated tax payments.
If your income is over $150,000 (married) or $75,000 (otherwise), you need to pay 110% of prior year tax to avoid interest and penalties.
In this example, Jim and Pam would have to pay in $16,500 in 2017 based on this method if their income is over $150,000.
So, their estimates would need to equal $6,500.
So, you can pay your estimates based on what your liability was in the prior year.
This method is easier to calculate because the amount of tax you paid in the prior year is not going to change.
However, you also have the option of basing your tax payments on your estimated current year tax liability.
This makes sense when you expect to owe less tax in the current year than you did in the prior year.
You can estimate what you expect your tax liability will be for the current year and pay in only 90% of that amount evenly throughout the year without being penalized.
The remaining 10% is due by April 15 of the following year when you file your tax return or automatic extension.
Using this method will require that you estimate your business income, so you are not likely to get it exactly right.
You may end up paying in 95% of your tax and will owe a little less when you file your return than you would if you paid in 90% of your tax.
You may pay in 105% of your tax, in which case you will be entitled to a refund when you file your tax return.
If you only end up paying in 85% of your tax, you will likely be assessed a small penalty and a little bit of interest, but it will be much less than it would have been if you paid in no estimated tax payments.
In the Jim and Pam example above, Jim and Pam expect to have $16,000 in tax liability in 2017.
They would only need to pay in 90% of the $16,000 tax liability for 2017, or $14,400.
Jim has $10,000 in withholdings again, so they would only need to pay in $4,400 in the form of estimated taxes.
They can pay the remaining $1,600 when they file their return or when they file an automatic extension before the April 15 due date.
Even though this is greater than the $1,000 threshold mentioned earlier in this post, you will not be assessed any interest and penalty by covering 90% of your tax evenly throughout the year.
In the examples above, the logical option would be to pay estimated taxes based on the current year liability laid out in the second example.
However, in a real life example, your current year tax liability is usually unknown until after the end of the year, so it is often easier and more practical to use the prior year tax as your baseline.
You don’t have to pay the lesser or greater of the two options.
You can pay either amount.
When to Pay Estimates
While you will often hear estimated tax payments referred to as quarterly payments, they are not actually due quarterly.
The payment due dates are:
- April 15
- June 15
- September 15
- January 15
If you’re working with an accountant and have to make a state estimated tax payment, they will probably recommend that you make your 4th state payment before December 31 because there is a tax benefit to doing so.
Paying your estimated taxes evenly throughout the year by these due dates will prevent you from being assessed any penalties or interest by the IRS.
If you are using the 90% method discussed above or don’t completely cover your tax liability with these quarterly tax payments, any additional tax due needs to be paid by April 15 of the following year to avoid additional penalty and interest.
This applies whether you file your return before the initial April 15th due date or request an automatic extension to file your return by October 15.
What if You Don’t Pay
If you don’t pay your estimated taxes (or don’t pay enough) I have good news and bad news.
When you owe over $1,000 when you file your personal income tax return, you will also be assessed penalties and interest based on the unpaid amount (unless you pay estimates based on the guidelines laid out above).
That’s the bad new.
The good news?
You aren’t going to be locked up.
And the penalties and interest assessed by the IRS are not crippling.
The failure to pay estimated tax penalty typically hovers around 3% per year.
The IRS usually recommends that you file your return and they will calculate and assess any penalty and interest due by sending a tax notice.
However, your tax return preparer may estimate the penalty for you and report it on your tax return.
If your tax return preparer does this, you would only get a notice if the amount they estimate is wrong.
The IRS penalty and interest for underpaying estimated tax hovers around 3%.
Many small business owners think their money is better off and will yield a greater than 3% return being invested in their business.
Others are willing to pay the penalty to avoid having to deal with estimated tax payments.
You can do this too as long as you budget accordingly and know that you will have one, bigger payment due when you file your tax return.
As I mentioned in the introduction of this post, this discussion is only about Federal taxes.
If you also have a state income tax or other business tax, the penalties and interest could be much different.
For instance, in Maryland where I have practiced for over a decade, the penalty and interest rate for underpaying estimated taxes hovers around 13%.
So, I always recommend that clients at least pay their Maryland estimated taxes.
This will vary depending on what state you are in and will require a discussion with your personal tax advisor.