If you are self-employed, earn 1099 income, don’t have sufficient tax withholding, or even have changes to your financial situation during a tax year, you may be wondering about Estimated Tax Payments. Since our tax system is a pay-as-you-earn system, taxes are due when you earn the income, not at the end of the year. For most people who earn wages from an employer who withholds wages, the employer does the math part of it and forwards the tax withholding to the IRS as required, throughout the year.
Some people work only for themselves. Some people work under contract for an employer who does not withhold taxes (commonly called “1099” for the IRS reporting form number). Some people may have a small business on the side- whether it is walking the neighbor’s dog, consulting on a website, doing in-home parties like Mary Kay or Pampered Chef, or being a sign waiver, if the money you earn comes to you without the IRS getting their hands in the pot first, you may owe Estimated Tax Payments. A lot of people “oops” forget to mention this to the IRS when they file their taxes and end up paying the penalties for accuracy and unreported income. Technically, all income should be reported to the best of your ability when you file and sign your tax return, under penalty of perjury. Trust me on this- while you may not want to pay taxes on this side income, you will end up paying more- sometimes much more- if the IRS comes back and tells you later that you did your taxes wrong by leaving out income and that they are going to help you fix it and get you set up to pay the new tax balance, along with interest and penalties.
Now, if you work on the side or have a spouse who works for wages while you are self-employed, you may be able to still cover your tax liabilities through tax withholding. That just requires you to more accurately complete the W4 form requesting the employer withhold more to cover the as-yet untaxed income. Basically, have your employer withhold enough so that you don’t expect to owe at the end of the year, even including all the extra income. Remember that state taxes are often quite different from IRS tax issues or withholding, and so you may need to either change more than 1 form, or you may need to do some more legwork to make sure that your state taxes are properly being paid and covered.
So how much do you have to pay? There are several forms you can complete to calculate that number. There are also some good guidelines you can use to limit the penalties and interest you may otherwise have to cough up. The basic rule is this, per the IRS: Pay at least 90% of what you expect to owe this year (based on the calculators and a Profit and Loss form, etc) OR Pay 100% of what you owed last year, expecting essentially the same input and output from year to year. Also, make sure that when you file your tax return, you owe less than $1,000, and you avoid late at least most of the late payment penalties. Obviously this won’t work the first year you are in business for yourself, won’t work if your income fluctuates drastically from year to year, and won’t work if you only worked for part of the previous year. In those cases, you are probably back to the worksheets and calculators. Check out IRS Publication 505 Tax Withholding and Estimated Tax or Form 1040ES Estimated Tax for Individuals at www.irs.gov if you need the actual calculators. If you are doing the 90%/100% calculation, your quarters are potentially all going to be equal. That doesn’t mean that they have to be- for example, if you run a pool cleaning business in Alaska, you probably make most of your money in a short timeframe, and not in January. If your income does fluctuate, you can break it down for the IRS based on that fluctuation if you prefer.
When do you have to pay? Estimated Tax Payments are due quarterly. So to cover money made in January/February and March, you pay by April 15. April/May/June is due by July 15. July/August/September is due by October 15. And October/November/December is due by January 15. Although since the IRS is the IRS, you can have until January 31 IF you can get it together to file your return by then and can pay the balance off in full, also by January 31. If you prefer to keep a monthly budget, you can do that too. The IRS really doesn’t care how often you want to make payments, so long as they get the payments you are required to make. For this, rather than making 4 quarterly payments, make monthly or weekly payments.
How can you pay? This is the easy part. You can mail payments as indicated in the above mentioned Form 140ES, based on your address. You can take your payment to a local IRS office. You can pay through a bank (especially if you have a large enough business where you have employees and have other payment requirements). You can pay online using a credit card, though the sites charge a convenience fee to do so, and so I don’t like this option much. Or you can apply for a password and use the FREE service at www.eftps.gov. Once you get a password, you can schedule payments up to 120 out, coming from your bank account. If you do this- make sure you indicate the current year and ES or ETP (for Estimated or for Estimated Tax Payment) and preferably the quarter you are paying. This annotation on a check may look something like this “ES 2011/Q3” or “ETP 201112.” The key is to make it clear where you want the IRS to apply the payment. Since the IRS charges penalties for quarters where you don’t pay or don’t pay enough, it would be a shame to have paid the money in but not told the IRS where to apply it, especially if that meant paying penalties later.
Why should I pay? This is a much bigger question, and I will avoid all of the philosophical and political discussion for now. On the purely financial side, since the IRS does charge penalties whenever you aren’t paying, or aren’t paying enough, you should pay as you go simply so you can pay the least. Also, if you start to fall behind, it gets harder and harder to get caught up. If you have other balances with the IRS, they will not consider any type of resolution until you are fully compliant for the current year. Imagine the difference in finding this out in January (when you can start fresh) or finding out in September or October that you now not only have to catch up on 3 quarters you should have already paid, but you also have to be paying for the current quarter (and maybe dealing with levies due to other balances, etc). On the fiscal side, if you are only self-employed, your Estimated Tax Payments are your required contributions to Medicare and social security. If you think you might want to take advantage of these services some day, you want to make sure you get the proper credit for having paid in while you are working. Plus, if you are self-employed, you do get some pretty awesome tax breaks for making the Estimated Tax Payments.
And remember- if it gets too complicated, if you find yourself falling behind, or if you just don’t like to do the paperwork: find a professional to help you. The IRS is very willing to audit your returns and have you owe a lot of money. If you are self-employed and dealing with ETPs, possibly for the first time, find yourself a CPA, experienced tax preparer, Enrolled Agent or Tax Attorney who can guide you through it. You may be very glad you did it right the first time.