For most taxpayers, estimated tax payments will never be necessary. Most people pay their taxes through their employer via the withholding system. If you’ve earned $100, you are going to have $6.20 taken out for Social Security (up to the annual ceiling, which is $142,800 of wages in 2021) and $1.45 taken out for Medicare, then you will have federal income tax withheld based on your responses to Form W-4 that you probably filled out in the first day or two of starting your employment. That federal income tax withheld is used to offset your tax bill and if you are overpaid, you get a refund. The average taxpayer will analyze their tax situation by the size of their refund, which doesn’t help explain enough about what is going on. I feel that looking at your effective tax rate is more appropriate. This would be the total tax you pay divided by your taxable income.
If your W-2 withholding rate (box 2 of the W-2 divided by box 1 of the W-2) is less than the effective tax rate, you likely had to pay on April 15 with your tax return. This could mean you owe estimated taxes going forward. If that withholding rate is too high, you get a refund and a badge of honor for the interest free loan you’ve made to the U.S. government. The only way to get interest from the IRS is when they significantly delay your tax refund, which sadly is becoming more common (but hey, at least they pay 3%, who else pays that?).
More commonly, estimated tax payments are due from self-employed individuals who operate their businesses as sole proprietors, partners in partnerships/LLCs, or S corporation shareholders. These taxpayers do not have a withholding system taking taxes from them at regular pay intervals and the IRS doesn’t want to wait the whole year to get their payments of income tax, and Social Security and Medicare. (Side note: I cannot imagine the lack of compliance this country would have if not for the withholding system. Paying taxes hits VERY different when the money has gone to your bank account. With W-2 withholding, you never get to have it and paying it is much easier to handle psychologically.)
If individual taxpayers owe more than $1,000 after factoring in their W-2 withholding, they are liable to make estimated tax payments to cover the difference or suffer the consequence of the underpayment penalty. The underpayment penalty is simply an interest charge, and the rate varies, but has held steady at a 3% annual rate since July 1, 2020. When my career started in 2007, it was 8%, but as interest rates have gone down for our mortgages, rates have gone down with the IRS as well. At a 3% annual rate, it is not uncommon for taxpayers to avoid estimated tax payments if they are borrowing money at higher rates. Think of the underpayment penalty as a nondeductible interest charge, but at a low rate of 3%. The downside of that approach is that come April 15, all that unpaid tax is due, but it is still cheap money to borrow for a short-term loan.
How do I know what to pay in estimated taxes?
The IRS has multiple ways to calculate and pay estimated taxes without penalty, and some are easier than others.
Prior year safe harbor
The IRS will allow you to use the prior year as a guide for what you owe this year, and because this is easy to calculate, it is the most common approach taken. For 2021 estimates, you look at the 2020 return to calculate it.
For taxpayers with adjusted gross income (AGI) at $150,000 or higher, your prior year total tax liability is multiplied by 110%. This would be reduced by any expected W-2 (or other) federal income tax withheld. If a positive number remains, this must be paid in four equal installments. If prior year AGI is less than $150,000, the 110% goes down to 100%.
Now let’s talk about one of the dumber things I’ve never understood about this. I’ve always heard these payments referred to as quarterly payments. But the payment schedule is anything but quarterly.
Due dates for individuals are:
April 15 for the first quarter (yes, you owe your first installment on the same day as you owe for the prior year – tough day for some),
June 15 for the 2nd quarter,
September 15 for the 3rd quarter,
January 15 for the 4th quarter
You may have noticed this isn’t quarterly because it isn’t. I know there have been pushes to move June and September a month back to accomplish a true quarterly system, but I wouldn’t hold my breath on that.
So, if your prior year (2020) tax liability was $40,000 and your current year (2021) W-2 withholding is $30,000, the calculation for estimated taxes is this. $40,000 * 110% = $44,000. That is reduced by the $30,000 of 2021 federal income tax withheld and $14,000 remains. This is divided by the 4 quarters to arrive at $3,500 per quarter. These payments would be due on or before the due dates above. If using the mail, a postmark on those dates is acceptable, but nowadays, paying online is the way to go although it does avoid the float achieved by mailing. Considering that floats will net you a couple pennies in today’s interest rate environment, I’d go with the safety and security of online payment on the due date.
For context on the cost of non-payment of this at the required dates; paying all the tax due on April 15 rather than prepaying costs $280. Below is a rough calculation of how the penalties are computed and would be within a few dollars of the IRS calculation due to differences in days in certain months.
Q1 – interest is computed for a full year - $3,500 * 3% = $105
Q2 – interest is computed for 10 months - $3,500 * (3%*10/12) = $87.50
Q3 – interest is computed for 7 months - $3,500 * (3%*7/12) = $61.25
Q4 – interest is computed for 2 months - $3,500 * (3%*3/12) = $26.25
Total = $280.00
*** This example assumes payments are made on the due date. Paying early or late will change the calculations. If paying late, ALWAYS PAY ONLINE using IRS Direct Pay (https://www.irs.gov/payments/direct-pay) since the IRS treats late payments as paid when received rather than when postmarked. Once you are a minute late, that standard applies and the IRS isn’t opening mail at the rate they used to. The old adage that the IRS centers where payments are received are always open and ready for mail is no longer true, which I have to admit is a pretty big surprise since this money is how our government, you know, exists……
Current year 90% safe harbor
The prior year safe harbor method assumes you are doing better in 2021 than 2020 since they are taking last year’s tax bill and adding 10% (if AGI > $150,000). If your income is equal or down, the last thing you will want to do is pay a higher amount than you need to.
There is another safe harbor based on 90% of what you would owe in the current year. This is more work to calculate because it relies on proper estimation of your income during the year. It requires staying on top of your current year income tax situation and requires more work for you or your tax professional to compute, but it could be worth it to you if you are trying to conserve cash.
Recall that a 3% nondeductible interest charge on untimely estimates, is a small cross to bear overall, and it could be cheaper than the fees to calculate these payments quarterly. This rate is subject to change, but it is generally cheap compared to the interest rate environment for short term loans.
The calculation is going to require a full estimation of your income taxes for the year. That tax liability would be multiplied by 0.9 and reduced by withholding to arrive at the amount to pay in quarterly installments. It is assumed income is earned evenly throughout the year.
Same example as above but instead the $40,000 tax liability is calculated for 2021 taxes. The $40,000 is multiplied by 90% to arrive at $36,000 and that is reduced by the $30,000 of withholding leaving $6,000 to pay in quarterly estimates. $1,500 per quarter is due using this method.
Annualization method
This is a similar method to the 90% safe harbor but requires even more work. Since income is often earned unevenly throughout the year, you go quarter by quarter to determine the tax liability in each quarter. 90% of the tax in the current year is due by the end of the 4th quarter, but the way it is paid would be based on when you earned the income.
Using this method will take a lot of your time or your tax pros time but can be valuable when income is earned primarily near the end of the year.
No Prior Year Tax Exception
If your prior year tax return generated $0 tax liability (liability is not the same as refund!) on line 24 of your 2020 Form 1040, you will not owe estimated taxes in 2021, period! This could result in a large balance due on April 15, 2022, if you’ve had a good year, but no estimated tax penalties will be calculated with a $0 tax year prior.
Note, for corporations, this exception only applies to the 1stquarter payment and the 2nd through 4th quarters require use of the current year safe harbor method. Additionally, the 4thquarter payment is due one month earlier on December 15.
Conclusion
Estimated taxes are a necessary evil of being in business, but my hope is that you come away from this understanding that these “penalties” are just an interest charge for holding onto your money. If your cash is earning negative interest due to inflation, there is likely no value in not prepaying an inevitable expense, but if your money is being used to earn more than 3%, it isn’t all that bad to wait to pay, just don’t shoot the messenger when that April 15 tax bill is high!
If you have questions on estimated taxes or any income tax matter, feel free to contact me at chris@juliencpa.com for representation.