Simply put, estimated tax is a form of taxation imposed on income that is not taxable by withholding. Income from self-employment, alimony, cash prizes and awards, payment of lease, interests, dividends, and sales of assets are some of the types of income included in this category.
Who pays estimated taxes?
If a person is employed by a company, it’s the company’s duty to deduct the necessary taxes from their employee’s salary on a monthly basis. This is commonly called withholding tax. The employer generally handles all monthly tax withholding for both state and federal taxes.
However, if you are not an employee (i.e., your income does not come from an employer), are self-employed, or have other income that is not subject to withholding tax — then you may need to pay estimated taxes on a quarterly basis.
More specifically, a person will probably have to pay estimated tax if they anticipate owing $1,000.00 or more upon filing their income tax return. This applies to people who are self-employed, sole proprietor or partner business owners, and shareholders of S corporations.
A person will also need to pay estimated tax if they are part of a corporation projecting to pay $500.00 or more on their tax return.
Last, if a person has incurred a tax liability on their previous tax return, they will most likely have to pay estimated tax. IRS tax form 1040-ES outlines all of the different types of income and situations that can lead to paying estimated taxes.
How to estimate the amount of tax to pay
For those who assume that they have to pay estimated tax, here is an easy guide on how to calculate your estimated tax.
You will first need to find your expected adjusted gross income, your taxable income, your previous year’s taxes, a list of potential deductions, and your credits. To compute estimated tax for the present year, you will check your last year’s income, deductions, and credits, and use them as a starting point. The federal tax return from the previous year can also be used as a basis for comparison.
Form 1040-ES also has details to help compute estimated tax. First, estimate all income for the year. Then check to see if this projected amount is too high or low for the most recent full quarter (which you should be able to calculate based on your invoices and checks).
If the estimate seems too high or low, refigure the amount until the projection for the next quarter seems reasonable. Changes may also need to be made to compensate for possible adjustments in finances and anticipated updates in the tax laws.
At the end of the day, remember that the goal is to come up with an amount of estimated tax that will be as close to the actual year-end amount as possible so that any amount owed on the tax return is as small as possible … and to avoid any fines from the IRS.
Paying estimated taxes
Payment for estimated tax is done quarterly or after every three months. Failure to pay or not paying enough by the deadline could mean incurring penalty charges or in owing taxes. Note also that these penalties can be imposed even on those who will receive a refund on their income tax return at the end of the year.
Because these payments are estimates, it is possible to pay less than the estimate without incurring a penalty (e.g., if your income has changed and you are no longer making as much money). The IRS is more concerned that payments are made; not that they’re made to the exact amount of the estimate.
For both individuals and businesses, the most efficient method of paying estimated tax is by utilizing the Electronic Federal Tax Payment System (EFTPS). Depending on what is more convenient financially, you have the option to pay estimated tax in a staggered option. You can choose to pay weekly, bi-weekly, monthly, or once per quarter.
Whichever scheduling method is chosen, what is important is that the accumulated total payment per quarter is equal to or more than the quarterly estimated tax in order to avoid owning a large amount at the end of the year.
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