Estimated Taxes: Important Series for the Self-Employed & Those With Alternative Income Part 1

For this 3 week series we will be covering different facets of estimated tax.  You’ll learn the basics, how to avoid underpayment of estimated taxes and some new strategies to replace the traditional monthly payments. 

THE BASICS OF PREPAID TAXES

Estimated taxes are generally required for individuals who are self-employed or sole proprietors, partners, and S corporation shareholders who expect to owe $1,000 or more in taxes. The reason for this setup is that the US operates on a pay-as-you-earn tax system. Taxes must be paid as income is earned, either through withholding or through estimated payments. 

In the latter case, taxpayers must prepay either 100% of their prior-year taxes (substitute 110% for higher-income individuals) or 90% of their current year taxes—whichever is greater. If you fail to do so, you can be subject to penalties. IRC §6654 details both the consequences of failure to pay and the exceptions to underpayment penalties.

For federal tax purposes, if you expect to still owe $1,000 or more after your tax withholding, you should be prepared to make estimated payments. IRS Form 2210 can be used to calculate the underpayment of estimated tax penalty. Many taxpayers in this category use the general rule of thumb of taking your annual shortfall, dividing it by four, and making quarterly payments of equal amounts. This method can work well if your income arrives in regular time intervals and predictable amounts—as is often true for interest and dividend income, royalty payments, and some types of self-employment income with a regular payment cadence. 

However, if your income is not received in predictable amounts or intervals, the IRS allows for an annualized payment method. IRS Publication 505 outlines the rules for tax withholding and estimated taxes, as well as worksheets for the annualized income installment method.

Taxpayers also have the option to adjust their withholding to cover additional taxes on other income by using Form W-4. Before the Tax Cuts and Jobs Acts (TCJA) of 2017, withholding allowances correlated to the personal and dependent exemptions taxpayers claimed on their individual income tax returns. The more allowances you claimed, the less tax was withheld. However, TCJA eliminated the personal/dependent exemptions, which meant the IRS has had to overhaul the withholding schema and design a new W-4 form. 

The IRS has also designed an online tax withholding estimator. Though many taxpayers find this tool to be robust enough for their needs, those who have numerous W-2 employers, wages paid unevenly throughout the year, or other unusual income patterns may find it hard to get their withholding amount right.

Estimating tax payments is just one of the many things that the self-employed have to deal with in the world of tax. There are so many other areas where businesses can legally cut back on the taxes they pay. Saving on taxes is the quickest way to increase your income! Join our DeTax University program for 16 classes that will guide you through saving taxes in areas like vehicles, short term rentals, retirement plans and so much more. Our goal is to save you over $10,000 in taxes each year. Click here for our special offer.