Following the U.S. economy’s crash in 2008,
more and more jobs were cut,, and salaried positions became increasingly
scarce. Many people experienced career changes and significant income swings.
Often, this meant facing unfamiliar federal income tax requirements, like
estimated taxes, which can confuse the newly self-employed. Accounting experts
have a few tips to help taxpayers avoid mistakes that result in penalties and
interest.

Who pays

Paying quarterly, estimated taxes can be a chore. Typically, people abhor dealing with
taxes even once a year. Sandy Zinman, a certified public accountant who serves
as the tax committee chair for the National Conference of CPA Practitioners,
says it can become extremely complicated and distressing.

Generally speaking, anyone who owes more than $1,000 in a given tax year, after
subtracting withholding and refundable credits, is required to pay quarterly
estimated taxes. Traditionally this applied to high income taxpayers because of
revenues from sources such as interest, dividends or rent.

“Estimated taxes generally do not apply for the low-income person,” Zinman said. “The joke
has always been that it’s a good problem to have. It means you made money
(during the year).”

Salaried individuals and those paid hourly wages typically do not pay estimated taxes.
Their federal income taxes are withheld from their wages throughout the year by
their employers. Self-employed individuals, however, are solely responsible for
ensuring that their federal income taxes are paid at the right time.

How to pay

The IRS requires that individuals estimate what their total income tax for the year
will be and divide it into four equal installments. The installments must be
paid on April 15, June 15, Sept. 15 and Jan. 15, unless the 15th falls on a
weekend or federal holiday, in which case the due date becomes the first
business day following the 15th.

Without exception, the payment — by check or money order accompanied by the correct IRS
voucher — must be postmarked by the due date, Zinman cautioned.

“If you miss it by one day you get slapped with a penalty,” he said. “If you’re out
of the country and your flight gets delayed a day … and you miss the
deadline, you get penalized plus interest. Who wants to pay a penalty?”

Estimating estimated taxes

When attempting to estimate your income tax for the year ahead, you are predicting
the future. If you underestimate, you may be penalized for the number of days
it remains unpaid, said Thomas Jensen, a financial planner based in Portland,
Oregon. The simple way to ensure that you pay what you owe, Jensen said, is to
pay at least 100 percent of the tax you paid the previous year, unless you have
some indication you are going to earn significantly less.

“If you think you are going to make less, calculate about how much and try to pay
90 percent,” Jensen said.

If you pay 100 percent, and still owe a little more at the end of the year, that’s
OK, Zinman said.

Jensen offers an example of a “safe harbor payment” — a payment that ensures
you will not be penalized. If you are married, filing jointly and your adjusted
gross income is below $150,000 (or below $75,000 if you are single or married
and filing separately), you may make a payment equal to 100 percent of what you
paid in income taxes the previous year or 90 percent of the tax for the current
year. Taxpayers whose adjusted gross income is $150,000 or more must make a
payment equal to 110 percent of the previous year’s taxes or 90 percent of the tax
for the current year.

In either case, you will still owe taxes at the end of the year, but you will not
face penalties and interest.

The IRS provides a worksheet for Form 1040 ES. It instructs taxpayers how to
estimate their taxes. It can get very confusing, says Tim Clegg, a Boston-based
financial coach and retired tax advocate.

“The 1040 ES instructions have elaborate standards, and I generally tell people not
to get all hung up on that,” Clegg said. “Just figure out a best guess of what
you owe and send it in.”

Don?t put it off

The potential penalties and interest of missed payments are bad, but they are
nothing compared to not preparing for a tax bill at the end of the year, Clegg
warns. He advises that you recalculate the estimated taxes at mid-year to see
where you are.

“You should be estimating at least twice a year and as early in the year as
possible,” Clegg said.

Whatever amount you estimate you will owe for the year, you should pay it early in the
year and get it out of the way, he says. Consider 25 percent for the mid-April
payment and 50 percent for the mid-June payment, he said.

“I have seen many start-ups suffer in their first or second year from the shock of
not really understanding paying estimated taxes,” Clegg said. “Heading into the
next year, they’re playing catch-up and finding themselves in the same
position, and complaining, ‘I’m never making money.’”

Even
worse, profits may have dried up at the end of the year, says Clegg. Following
his advice, a taxpayer will have a large chunk of debt wiped out in advance of
a downturn, he said.

“In that case, you’ve got options,” he said. “If you need to, you can do
the end-of-year push and pull, such as purchasing business equipment or
delaying billing until the new year.”

Card payments

The Internal Revenue Service allows for quarterly estimated taxes to be paid with a
credit or debit card, which it touts as a convenient way to pay during the
year. Card payments may be made over the phone, online or when e-filing.
Benefits include:

  • Documented proof of payment (taxpayers are
    issued a confirmation number and “United States Treasury Tax Payment”
    is included on the card statement); and
  • Delay of out-of-pocket costs and, if in
    enrolled in such a program, accumulation of miles, points, rewards or money
    back from the credit card issuer.

The IRS uses commercial service providers to accept card payments. According to the
IRS, neither it nor these providers store card numbers. Providers typically
charge a convenience fee, which appears on the card statement as a “Tax
Payment Convenience Fee.”

Taxpayers
may also opt to use the Electronic Federal Tax Payment System, which will draft
funds from a prearranged account following a phone call or an Internet request.

By Tim Parker | Investopedia