The great majority of people never have to cope with
the problem of quarterly estimated taxes because their taxes are withheld by
their employer. Most of them end up with more withholding than the taxes they
owe and they get a refund after filing heir tax return. But anyone who has
any reason to expect that they will owe more than $1,000 in extra taxes when
they file their tax return is required to make quarterly estimated tax
payments. If they don't make the quarterly payments, the government imposes a
penalty of 8% to 9% a year in the form of non-deductible interest on the
underpayment.
But if your total taxes due after deducting any
withholding is less than $1,000, there is no penalty for not making quarterly
estimated tax payments.
Anyone who is self employed is involved in a tax system
in which there is no withholding. Instead, the self employed have to estimate
how much taxable income they will have for the entire year (after all
deductions), how much tax they will owe, how much they will be able to deduct
for tax credits and how much they must pay in as quarterly estimates on April
15, June 15, September 15 and January 15. If they live in a state with state
income taxes, they must also estimate their total state income taxes and make
quarterly payments of those as well.
Not only do they have to estimate their federal and
state income taxes, but they have to estimate their self employment taxes as
well. The self employment tax is basically like the Social Security tax an
employer withholds from the pay of an employee -- but the self employed must
pay both the employee share and the employer share. The actual amount of the
self employment tax for 2003 is 15.3% of the self employment income for the
year. However, it does not apply to any self employment income in excess of
$87,000 (for 2003). Only the Medicare portion (2.9%) is applicable to
earnings above that level.
In order to compute your estimated taxes you have two
basic choices.
You can actually estimate your prospective income,
expenses, income taxes and self employment taxes and then pay that amount to
the government in four quarterly installments. However, if you underestimate,
the federal government will charge you from 8% to 9% per year (it changes a
little each quarter) for the underpayment. The penalty will apply to any
underpayments in excess of 90% of the actual tax due. Thus, if your final tax
bill is $20,000 and you have paid in $15,000, the penalty will be based on
90% of $5,000. Thus, you would pay a penalty of about 8.5% on $4,500 or about
$360.
To add insult to injury, if you file for an automatic
extension to file your return and if your estimated tax payments are
substantially less than the tax that is due, the IRS may assess a penalty of
5% per month for a late payment of your tax. The maximum late payment penalty
is 25% of the tax due.
The other choice is to base your current estimate on
the total amount (100%) of taxes you owed (before deducting any payments) in
the prior tax year. So, if your total federal income tax and self employment
tax for 2002 was $16,000 (in excess of any withholding), you can make three
quarterly payments of $4,000 during 2003 and one on January 15, 2004 and you
will owe no penalties for underpaying your 2003 estimated taxes.
For those with an adjusted gross income of $150,000 or
more, the minimum estimated tax payment for the year will be 112% of the tax
due for 2001.
How To Minimize Your Estimated Taxes
Perhaps it's overly obvious, but anything you can do to
reduce your taxes for the year 2003 will also reduce the amount of estimated
taxes you have to pay during 2004. It's as if every dollar of tax savings
or deferral is doubled. You not only save taxes on your 2003 tax return
but you also save an equal amount of estimated taxes for the year 2004
because you are reducing the amount you have to pay to avoid a penalty for
2004.
If you have any income that is subject to withholding,
and if you have some flexibility in requesting special adjustments in your
withholding, then any overpayments of income taxes withheld will be applied
to reduce your total unpaid tax and therefore the amount of estimated taxes
you have to pay to avoid penalties. If your employer would cooperate, you
could have almost 100% of your pay at the end of the year paid as withholding
and thereby avoid a penalty on an equal amount of underpaid taxes.
If your spouse is employed and can make an adjustment
in his or her withholding, that can also reduce your potential penalty for
underpaying your estimated taxes.
The underpayment of estimated taxes is not a crime
that will cause you to go to jail. It's simply a financial penalty to
encourage you to pay up on time. But if you are in a situation where you
would have to borrow from a credit card at 18% or more per year in order to
make estimated tax payments, the interest rate on the estimated payments
would be less costly.
As a general rule, the easiest way to deal with
estimated taxes is to base your estimate on 100% of the previous year's tax
(before deducting any payments) and to then pay in that amount (minus any
withholding) on a quarterly basis.
But what if your income is erratic and you have very
little income for the first half of the year and get some unexpected income
in the last half of the year? Normally, the estimated tax is computed for the
entire year and is then assumed to be due equally for each calendar quarter.
But when you file your tax return, there is an option that few people use or
even know about. You can compute your income and your taxes on a cumulative
quarterly basis. So if you have little or no income in the first two
quarters, you would not owe any penalties for failing to make payments in
those quarters. Any experienced tax preparer who uses one of the better tax
preparation programs should be able to help you with this calculation. If a
tax preparer tells you that you can't do this, get another tax preparer.
.jpg)
