The law requires that a certain level of tax be paid during the tax year. This can be accomplished through withholding of federal and state tax (in certain circumstances) on wages, pensions or Social Security benefits. If this does not meet your obligation, you should make quarterly estimated payments. Making quarterly estimated payments should help you avoid owing a large tax amount in April, and possible penalties and interest for not meeting your obligation.
How Much Tax Must You Pay During The Year?
If your total tax obligation for the year will be less than $1,000, it is not necessary to withhold or make estimated payments. You may pay your taxes by the following April without penalty.
However, if your total tax obligation will be greater than $1,000, at least 90% of an individual’s final total tax (income, self-employment, as well as other taxes reported on Form 1040—computed by the following April 15th) must be paid. This can be paid through either withholding or estimated tax payments to avoid underpayment penalties and interest.
For example, if your federal tax bill is $15,000, you must have paid $13,500 by December 31st through withholding, or by making quarterly estimated payments with your final quarter due by January 15th of the following year. The balance of the tax, $1,500, is due by April 15th of the following year.
Safe Harbor Rules
Many individuals cannot adequately compute their entire tax obligation during the year to meet the 90% threshold described above. In order to avoid penalties and interest for underpayment of tax, the IRS provides safe harbor rules for you rather than paying the 90% threshold.
The General Rule
This applies to taxpayers with adjusted gross income in the prior year of $150,000 or less ($75,000 if married filing separately).
The safe harbor for those in this income category is to pay 100% of the tax shown on the prior year’s return. The payments must be received through withholding and/or through quarterly estimated payments. The safety is also used when your prior year tax is expected to be lower than your current year tax.
For example, if your prior federal tax bill was $10,000, you must withhold $10,000 during the current year, make estimated quarterly payments of $2,500, or a combination of the two. If your current year tax bill is $20,000 and you met the $10,000 safety, you can pay the $10,000 due by April 15th of the following year, without penalty or interest.
The Special Rule
This applies to individuals with adjusted gross income in excess of $150,000 ($75,000 if married filing separately).
The safe harbor for those in this income category is to pay 110% during the current year, based on the prior year tax. The payments must be received through withholding and/or through quarterly estimated payments. The safety is also used when your prior year tax is expected to be lower than your current year tax.
If your federal tax bill was $95,000 last year, you need to withhold $104,500 for the current year, make estimated quarterly payments of $26,125, or a combination of the two. Remember, this is necessary if you believe you will have approximately the same taxable income, or higher, in the current year as you had in the prior year. If you know that your income will be lower in the current year, you can elect to make quarterly projections and only pay 90% of the actual tax due as described previously.
How to Make Quarterly Estimated Payments
In general, you are to make four equal installment payments based on your calculations. The first payment for the current tax year is due April 15th, the second June 15th, the third September 15th, and the fourth installment is due January 15th of next year.
If you have no means to have tax withheld (i.e., from wages) and your projected tax bill will be $10,000 (or your last year’s tax is $10,000), you should make four installment payments of $2,500 each.
If you withhold taxes through your wages or pension, but it is not at a high enough rate and you do not wish to adjust your withholding, you should make up the projected difference through estimated payments. If your projected tax bill will be $10,000 and you withhold $500 per month ($6,000 per year), you should make quarterly estimated payments of $1,000. This should make up the $4,000 shortfall.
Annualized Income Installment Method
This method is generally used by those whose prior year tax bill was much higher than they project for their current tax year. Under these circumstances, they may not wish to meet the safe harbor rules.
For example, if your prior year tax obligation included a significant gain from the sale of a business or rental property, you cannot calculate your income for the whole year at this time. Another example would be someone who quit a job to start their own business and cannot anticipate the future income amounts. For this method, you calculate your actual income and deductions for certain periods of the year. The income already earned is then annualized, the tax calculated and a percentage paid for that installment.
For additional information, call Henssler Financial at 770-429-9166 or [email protected].