Planning for taxes never ceases. Whether you are a business owner, independent contractor, or a company employee, tax planning is a year-round endeavor. One component of that planning is estimated tax payments. But who needs to pay them? How much needs to be paid? And, when are they due?
Tax Payments – The Basics
To fully understand the concept, let’s start at the basics. The IRS tax system operates as a pay-as-you-go construct. For the vast majority, this concept is accomplished through the federal tax withholding done by your employer for each paycheck you earn. At year-end, you file your tax return and collect a refund for any overpayment or pay any amount you may be determined to still owe.
In the event of a refund, no changes are required. If you owe more than $1,000, however, you will be asked to make estimated payments for the following tax year, which can often surprise many filers.
You may ask, “Do I need to make these estimated payments if I already have taxes withheld from my paycheck?” In short, no. You are still paying-as-you-go when taxes are withheld. However, you should consider adjusting your W4 to increase the amount withheld to meet the quarterly requirements.
You can determine the amount needed to be withheld by completing form 1040-ES, though this amount will be calculated if you use online software such as TurboTax.
If you elect to make quarterly estimates, your payment schedule will be as follows:
- Pay all of your total estimated tax by the tax filing deadline or in equal payments by (using 2023 tax dates):
- 1st payment – April 18, 2023
- 2nd payment – June 15, 2023
- 3rd payment – September 15, 2023
- 4th payment – January 16, 2024
Under Withholding Consequences
If you are required to make estimated payments and underpay the mandatory amount, the IRS has reserved the right to impose penalties and interest. Those penalties amount to 0.5% of the amount owed monthly, and for the part of the month the tax is not paid. The underpayment penalty cannot exceed 25% of the unpaid amount. The unpaid amount also accrues interest. The interest rate is based on the federal short-term rate plus 3%, currently 7% for individual filers.
No penalty will be applied if any of the following conditions are met:
- The tax filer owes less than $1,000.
- If you have paid taxes amounting to the smaller of:
- 90% of your current tax year liability
- 100% of the tax amount you owed in the prior filing year (depending on your adjusted gross income, this figure could increase up to 110%)
- The IRS will consider a penalty waiver under certain circumstances.
Cautions & Considerations
Suppose you live in a stable-income environment where you only receive income through salary or wages. In that case, modifications to your W4 will likely suffice in handling any shortcomings you might have from a tax-withholding perspective (as alluded to above).
However, if you have other income-producing means, it may be more complex.
For example, look at a Roth conversion. Any non-previously taxed proceeds converted from your traditional IRA to a Roth during the year will be deemed a taxable event, thus generating additional taxable income. This additional income may cause you to run afoul of the IRS mandatory withholding guidelines if not considered during the year.
This line of thinking holds for other income-producing events such as investment income, side gigs where tax withholding may not occur, or renting out a space in your home. The bottom line is that you will want to account for all sources of income you may receive throughout the year to ensure your tax withholding structure is adequate and in line with IRS guidelines.
Tax planning will always be at the forefront of comprehensive financial planning. Taking steps throughout the year can not only ensure you are not faced with a tax surprise at filing time, but it can also help ensure you aren’t subject to potential penalties for not meeting the IRS pre-determined payment conditions.
If you are uncertain about your current tax situation, it’s best to speak with your tax advisor and financial planner to avoid any unwanted negative consequences.
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