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Paying as You Go: Why You Might Need to Pay Estimated Taxes

by
Josh Trubow
MSFP, CFP® - Senior Financial Advisor

May 30, 2024

The picture shows an IRS form for withholding and estimated taxes.

April 15th tends to get a lot of focus when it comes to paying taxes, but did you know that the United States income tax system is “pay-as-you-go”? It can be unpleasant to file your return and learn that you underpaid and have a large tax liability. Even worse, you may be assessed a penalty for not paying as you go. To appease the Internal Revenue Service (IRS), there are two ways to pay your taxes as you go: withholding and estimated tax payments.  

While most employees have income taxes automatically withheld from their paychecks, others might need to make estimated tax payments throughout the year. And some may need to do both. This article explores estimated taxes, explaining who needs to pay them, how they work, and how to help avoid potential penalties. 

Who Needs to Pay Estimated Taxes? 

For most people, withholding is enough. However, individuals and businesses whose income isn’t subject to regular withholding may need to pay estimated taxes. Here are several examples:

  • Self-employed individuals: Freelancers, independent contractors, and business owners fall into this category. Their income is not subject to withholding, so they need to make estimated payments during the year. On top of this, self-employed individuals may be responsible for the full payment of taxes for Social Security and Medicare, amounting to 15.3%.  
  • Investors: If you receive income from investments like dividends, interest, or capital gains, taxes are not generally withheld. Selling a home is another source of potential taxable income. 
  • Certain W-2 employees: Even if you have a traditional job, there are situations where withholding might not cover your full tax liability. This could happen if you have multiple jobs, receive equity compensation, and/or your withholding is not large enough. In some cases, adjusting your Form W-4 and/or making estimated payments is necessary. 
  • Retirees: Pensions, annuities, Social Security, pre-tax IRA draws, and Roth conversions may add to a retiree’s taxable income. However, taxes may not be withheld automatically from these payments, or might be withheld at a default rate that is too low.  

How to avoid penalties 

Not paying enough taxes during the year can trigger an underpayment penalty. Paying the correct amount of taxes but doing so at the end of the year instead of throughout the year may also trigger a penalty.  

The IRS calculates penalties based on the difference between your actual tax liability and the amount paid through withholding and estimated payments. Thankfully, there are several ways to avoid these: 

  • Owe less than $1,000 after subtracting your withholding and refundable credits. 
  • Pay the lower of: 
    • 90% of the tax for the current year, or 
    • 100% of the tax shown on the return for the prior year, or 110% if your income is greater than $75k (single) or $150k (married filing jointly). 
  • Annualized income method: This method requires adjusting your estimated payments throughout the year based on your actual income. This can be especially helpful if your income is irregular and falls later in the year.  

If you do not currently pay estimated taxes and are accustomed to a large tax bill every April, you might consider making estimated payments to help smooth your tax liability over the course of the year and avoid underpayment penalties. You (or your accountant / tax software) might also complete Form 2210 to determine whether you have an underpayment of estimated tax. 

Even if you paid enough during the year and have a refund, you might still find yourself with a penalty for not paying as you earned your income. Something like the sale of stock or a home sale early in the year might trigger an income event that requires an estimated payment.  

The Mechanics of Estimated Taxes 

Think of estimated taxes as quarterly installments of your projected annual tax bill. The IRS sets four deadlines throughout the year: April 15th, June 15th, September 15th, and January 15th of the following year.  

But how do you estimate your income? The IRS provides Form 1040-ES and a handy worksheet to help you calculate your payments. You (or your accountant / tax software) can estimate based on previous year’s income and projections for the coming year. Remember, underestimating can lead to penalties, so aim for accuracy and consider overestimating to help avoid a penalty. If you pay too much, you will enjoy a refund when you file or can apply the overpayment towards next year’s taxes. Estimating taxes isn’t something you do once at the beginning of the year. You should review your income periodically and check in with your accountant to adjust if there are unanticipated sources of income that need to be factored in. 

To pay your estimated federal taxes, you can either use the IRS website to pay online, or mail a check along with a tax voucher to the address listed on the voucher.  

Although much of this article focuses on federal taxes, the same concepts apply to state taxes, and you may need to pay estimated taxes in your state as well.  

The Perks of Paying Estimated Taxes 

While paying taxes throughout the year might seem inconvenient, there are several benefits: 

  • Avoiding a large tax bill: Spreading out tax payments throughout the year helps smooth the tax bill and reduces the chance of a large tax bill surprise in April.  
  • Reducing the chance of penalty:  As I stated at the beginning of this article, federal and state taxes are pay-as-you-go. Paying estimated taxes helps avoid any underpayment or late payment penalties. 
  • Peace of mind: Knowing you’re up to date with your tax obligations reduces stress and potential future headaches. 

Seeking Help

Navigating estimated taxes can seem daunting, especially if paying estimated taxes is newer to you. Do not hesitate to seek help from tax professionals or software programs designed to guide you through the process. The IRS website also offers valuable resources and worksheets. 

Remember: Estimated taxes are a way to ensure you are paying taxes as you go throughout the year and avoiding potential penalties. By understanding who needs to pay them, how they work, and the benefits and pitfalls, you can make informed decisions and approach tax season with greater confidence. Sensible Financial can work with you and your tax preparer to estimate your income and raise cash from your managed portfolio to make estimated and year-end payments. Please reach out to your advisor if you have any questions.  

Please note: This article is for informational purposes only and should not be considered tax advice. Always consult with a qualified tax professional for personalized guidance.  

Photo by Kelly Sikkema on Unsplash

More articles by Josh Trubow Filed Under: Taxes Tagged With: estimated taxes, IRS, tax savings

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