Estimated tax payments: How to avoid big tax bills and penalties

If you earn income as a self-employed person or business owner, you likely need to make estimated tax payments throughout the year. Failure to make those payments can result in big tax bills due when you file your tax returns.

You may also face underpayment penalties of hundreds or maybe even a few thousand dollars.

Some of the most common questions I get from prospects and clients include the following:

• Do I need to make estimated payments?
• How much will the penalty be if I don’t make estimated payments?
• How much, and when, should I pay?

This guide will help you understand why you need to make estimated tax payments, how much you need to pay and when, and how much the underpayment penalty will be if you don’t make your payments.

Why you need to make estimated tax payments

Our tax system, both at the federal (IRS) and state levels, expects taxpayers to “pay as you go,” meaning you should be paying in throughout the year. For employees, this is relatively easy. The companies they work for withhold some of their salaries each time they pay them; then, they send the withholdings to the IRS and state revenue agencies throughout the year.

Business owners and self-employed workers need to make those payments for themselves. If they don’t, the IRS and many state revenue agencies charge underpayment penalties based on how much should have been paid and how much is owed at tax time. The penalties are usually not severe, ranging from a few hundred to a few thousand dollars; however, the penalty can be entirely avoided by making a few estimated tax payments throughout the year.

The rest of this article focuses on how the IRS calculates underpayment penalties and how to avoid them. Your state may have different rules.

You can avoid an IRS underpayment penalty in one of three ways:

1. Owe less than $1,000 in tax after withholding and refundable tax credits (but estimated payments don’t count for this calculation),
2. Have combined withholding, refundable credits, and estimated payments equal to at least 100% of last year’s tax liability, or
3. Have combined withholding, refundable credits, and estimated payments equal to at least 90% of this year’s tax liability.

How much you should pay for estimated taxes

You have three methods of figuring out how much you should pay in estimated taxes:

1. The passive method,
2. The presumptive method, and
3. The effective method.

The passive method

You may have received pre-printed vouchers—IRS Form 1040-ES—with your return, indicating how much the IRS recommends you pay. These figures are based on your last tax return. As indicated above, you should pay at least 100% of last year’s tax liability to avoid an underpayment penalty.

I call this the “passive method” because you’re passively letting the IRS tell you how much to pay based on year-old data. You should grow your businesses over time. Your business numbers should change year to year, hopefully upward. Relying on last year’s tax return estimates will not do the job for you. You may avoid a penalty, but you also face a remaining balance due at tax time.

The presumptive method

The presumptive method takes a percentage of your income, sets it aside, and pays it to your taxes.

I call this the “presumptive” option because you presume to know your effective tax rate. Many factors affect the effective tax rate, including actual taxable income, itemized personal deductions, and credits.

It also conflates gross income with net income. Calculating estimated payments based on revenue could lead to wildly inaccurate approximations. Your flat percentage of your gross business income will never equate to your effective tax rate.

The effective method

The effective method—my preferred method—is to hire a tax professional to prepare a tax projection for you. A tax projection takes your mid-year income and other relevant information, annualizes those figures, and uses existing tax rules to determine your projected liability. This is the closest you can get to an actual estimate of your tax liability and how much you should pay before being able to file your tax return.

Your business income could change between July and the end of the year. If that happens, your tax professional can run a new tax projection. You can get your estimated payment such that your refund or balance due will be as close to zero as reasonably possible. This approach minimizes your likelihood of owing underpayment penalties while maximizing your cash flow throughout the year.

When you should make estimated tax payments

The IRS has four estimated tax payment deadlines:

• April 15
• June 15
• September 15
• January 15

NB States may follow the IRS’s deadlines or have their own. Check with your tax professional or your state’s revenue agency.

If you have to pay an underpayment penalty, the calculation considers how much you paid before each deadline. Payments made before earlier deadlines reduce the penalty more than payments made before later deadlines. This encourages taxpayers to pay more earlier.

How to make estimated tax payments

Making estimated tax payments to the IRS is relatively easy.

Click here for a video walkthrough of the steps listed below.

1. Go to irs.gov/pay.
2. Below Pay Now, click the blue button with your preferred payment method. (I’m using Direct Pay.)
3. Click Make a payment.
4. Choose the applicable options. To make an estimated tax payment, select “Estimated Tax” for Reason for Payment, “1040ES” for Apply Payment To, and the correct tax year for Tax Period for Payment.
5. Verify the information and click Continue.
6. Enter the correct information to verify your identity and click Continue.
7. Enter your payment information and click Continue.
8. read the Disclosure Authorization and click I Agree.
9. Review, sign, and click Submit.
10. Take a screenshot of the confirmation page and save it with your tax files.

If you need help figuring out your estimated tax payments or managing your business taxes, click here to schedule a discovery call.