What are estimated tax payments and do I have to do it?
Let’s start with a basic definition. The IRS defines estimated tax as the method used to pay tax on income that is not subject to withholding. This income includes earnings from self-employment, interest, dividends, rents, and alimony. Taxpayers who do not choose to have taxes withheld from other taxable income should also make estimated tax payments, such as unemployment distributions that you elect not to withhold tax.
The short version: if you expect to get a W-2, then the estimated tax is not for you. Haha
Where To Pay
This payment usually gets made to both the federal and state governments (except in states with no income tax). The payment is usually made along with a voucher to ensure accurate account assignment. Think of it like an escrow account for your tax bills. You pay into this escrow account every quarter, and when it’s time to file your annual tax return, the government will offset the balance due with the payments in the “escrow account.” Anything left over will be sent back to you in a refund check, or a bill will be due for any remaining balance.
Why do I have to pay it?
You have to pay because it is required by law, tax law actually. And if you do not pay the estimated tax, you get penalized. So, if the goal is to save money, then it benefits you to pay quarterly. It’s like a payment plan; $10,000 might be easier on your budget if you could break it into $2,500 increments. If you were working for an employer that paid you a salary with payroll tax included, then you would be doing this process anyway, except by paycheck rather than self-submission.
When it is due and how to pay
Estimated tax is due quarterly or by the 15th of the month following quarter-end. What is quarter-end, you might ask? It occurs every three months. January to March would cover quarter 1, and the payment would be due by April 15th. April to June would cover quarter 2, and the payment would be due by July 15th and repeat. So, in other words, all of the income that you made after expenses, during those three months must be summed up and multiplied by a tax percentage. The percentage comes from the instructions on the payment voucher. The total of that calculation is written on the voucher and placed in an envelope for mailing, along with a check for payment.
And if I don’t pay
If you do not pay, the IRS (and most states) include a failure-to-pay penalty when filing your taxes at the end of the year. Remember, this is like an escrow account, so if you do not add to your escrow account on time, the government adds penalties. And maybe that does not matter so much to you in the moment, but if you get in the habit ofnot paying estimated tax, you open yourself up to this downward spiral of non-compliance. And non-compliance is expensive, unnecessarily.
For example, let’s say your tax bill is $10,000 at the end of the year, and you did not make any estimated payments throughout the year. Maybe you did not think you could afford it, or have poor financial management habits. When the tax bill and payment are due on 4/15 of the following year, you will fall behind and incur a failure-to-pay penalty. Remember, $2,500 four times is a lot easier than $10,000 all at once. So now you owe the original $10,000 tax bill plus a failure-to-make-estimated-payments penalty and a failure-to-pay tax due penalty plus interest. And just like that, the amount due shoots up to $11,050 (not actual figures). And you couldn’t afford to make the quarterly payments, and you probably still can’t afford this excessive amount due either, so you have to enter into a payment plan. Now you have a payment plan for old taxes and an estimated tax due for the new year. And the cycle goes on and on. You see how quickly this gets out of hand?
The fact is we make it harder on ourselves by not complying with estimated tax rules. We end up owing more and lost in a cycle that we are waiting for some windfall to fix. Do not get stuck waiting for a windfall. With every dollar you make, move .30 of it to a savings account and only work with the money you have leftover. It’ll save you time, money, and mental space.
As always, be well, and never quit.