You’ve nailed down a couple side gigs to boost your income this year — congratulations on being financially savvy.
But now that it’s tax season, you might be biting your fingernails as you wait to see what impact — if any — this extra income has on your tax return.
If you plan to keep plugging away at all your money-making enterprises, you should familiarize yourself with the concept of estimated taxes.
Estimated taxes are one way the IRS expects you to pay taxes as you receive income throughout the year. To figure out your estimated tax payments, you’ll need to look ahead at the year to come and guess how much income you’ll earn.
If you receive a regular paycheck, you already know that some of your income gets withheld for taxes and other fees each pay period.
But if you don’t receive a traditional paycheck, or if you earn other income on the side, you may need to make estimated tax payments. We’re looking at you, freelancers and side gig aficionados.
What Are Estimated Quarterly Taxes?
“Though we associate the payment of taxes as a once-a-year, April 15 occurrence, that is not how the system is designed,” said Pamela Kornblatt, president of Tax Strategists, Ltd. “The United States tax system is designed to be a ‘pay as you earn’ system, which means that as income is earned, taxes should be paid. In a lot of cases, the ‘pay as you earn’ idea happens behind the scenes through withholding. When you are a regular employee, tax is withheld and submitted on your behalf throughout the year.”
You only need to worry about making estimated tax payments this year if you expect to owe at least $1,000 in taxes for the year — after deductions, expenses and the amount withheld by an employer. (If you’re a fisherman or a farmer, the IRS has a whole different set of estimated taxes rules for you.)
“If you are self-employed as a freelancer, contractor or home-based entrepreneur, you most likely don’t have taxes withheld from your pay throughout the year and are subject to estimated taxes if you expect to owe $1,000 or more for your taxes,” according to Lisa Greene-Lewis, a CPA and tax expert for TurboTax.
Even if you’re not a full-time freelancer or contractor, you could still owe estimated taxes. There are tons of reasons why you may need to make payments throughout the year rather than waiting until April to deal with your taxes. Just to name a few, if your employer isn’t withholding enough from your paychecks, if you receive alimony or win a cash prize, or if you bring in tons of side gig income, you may need to take action.
Instead of making one big payment in March or April during tax season, the government wants you to make quarterly installments, meaning you’ll need to make a minimum of four payments each year: one in April, one in June, one in September and one in January (of the following year).
You can pay online, by phone or through the mail, according to the IRS. You can pay once a month or once every two weeks — whatever you prefer — as long as you’ve paid enough at the end of the quarter.
So what does this mean if you’re bringing in extra income on top of your regular job? It depends on how much money you expect to make, how much your employer is withholding from your paycheck, and how many deductions you expect to have.
If you expect to owe less than $1,000 in taxes for the year, you don’t need to do anything. But if you expect to owe more than that, you’ll want to start making estimated payments as soon as possible.
How to Calculate Estimated Taxes
If you were a U.S. citizen or resident and had no tax liability last year (you didn’t owe any taxes or you didn’t have to file a tax return), the IRS doesn’t require you to make estimated tax payments this year.
But if you owed taxes last year, and you expect to owe at least $1,000 this year, keep reading.
Many people use last year’s tax bill to guess how much they’ll owe each quarter this year.
The IRS also created Form 1040-ES, a worksheet that uses your income, deductions, credits and other factors to estimate your taxes for the current year. Tax preparation software programs can also help you figure out your estimated taxes.
Of course, you’re just guessing at how much income you’ll earn in the coming year. The IRS understands this, and if your estimated earnings are too high or too low, you can refigure your estimated tax for the next quarter.
“You can calculate your estimated tax by figuring your expected adjusted gross income, taxable income, deductions and credits,” said Joshua Zimmelman, president of Westwood Tax & Consulting. “Most people use their income, deductions and credits from the previous year as a basis for this estimation. Then, you divide the year up into four payment periods. You can recalculate this estimate every quarter, so you don’t have to worry if your first estimate was too low or too high.”
If your side gigs are seasonal (maybe you write letters to kids from Santa) and you receive more income in one quarter than you do in the others, the IRS will let you make unequal estimated tax payments.
It’s important to note that you still need to file your taxes every spring, just like everybody else, even if you make estimated payments throughout the year.
“Paying estimated taxes does not mean that no taxes will be due at the end of the year when the tax return is filed,” Kornblatt said. “Since the required amount for estimated payments is based on last year’s taxes, additional taxes may be owed or refunded if this year’s tax situation is different.”
Penalties for Underpaying When Quarterly Taxes are Due
Though the government understands you’re just guessing how much income you’ll earn in the year ahead, it also wants you to try to be as accurate as possible.
To be on the safe side, you need to pay at least what you owed in taxes last year (100% of last year’s tax liability) or 90% of what you owe this year, whichever is less.
If you don’t pay enough throughout the year through estimated payments or taxes withheld from your paychecks, you could face an underpayment penalty from the IRS.
“Figuring out estimated taxes the first year is always the trickiest, since you may have no idea how much you’ll make, but there is one way to play it safe and avoid underpayment penalties,” said Wendy Connick, an enrolled agent and the owner of Connick Financial Solutions. “If your quarterly tax payments add up to 100% of your last year’s taxes, the IRS won’t punish you even if it turns out your payments were too small for the current year.”
If you owe a penalty, the IRS will send you a bill after it processes your tax return. In short, you may have to write a bigger check to Uncle Sam when you file your return.
Unfortunately, there’s no simple way to calculate this penalty, according to Abby Eisenkraft, an IRS enrolled agent, accredited tax advisor and tax preparer, retirement planning counselor and the author of “101 Ways to Stay Off the IRS Radar.”
It depends on how much money you owe and how long you’ve avoided paying the IRS. The IRS figures the penalty separately each quarter, which further complicates things.
The IRS has a worksheet called Form 2210 that you can use to determine your penalty, or you can let the IRS calculate the penalty for you, Eisenkraft said. And, if you couldn’t make a payment because of a disaster or some other unusual circumstance, the IRS might let you off the hook.
Bottom line: If you expect to owe at least $1,000 in taxes for income you earn this coming year — after deductions, credits and withholding — you should make estimated payments every quarter moving forward.
It’s best to pay 100% of what you owed last year, just to be on the safe side so you don’t end up with an underpayment penalty. A tax expert can help you navigate the tricky world of estimated taxes if you’re looking for guidance.
Your Turn: What’s your tax plan for the coming year?
Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.
The post Avoiding Your Quarterly Estimated Taxes? Here’s How it Could Cost You appeared first on The Penny Hoarder.
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