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How to avoid estimated tax penalties

The U.S. tax system is based on the pay-as-you-earn concept. Every worker who gets a paycheck knows this by the amount of income and payroll taxes withheld each payday.

If you get money from other sources where withholding isn't in effect, Uncle Sam expects you to take care of your due taxes in a timely fashion, too. The mechanism for this is estimated tax payments.

Estimated taxes are paid via four extra payments filed with the Internal Revenue Service using Form 1040-ES.

1040-ES 2013 4th quarter payment voucher
 Click image to access the PDF version of Form 1040-ES, including all vouchers and instructions.

They are due each April 15, June 15, Sept. 15 and the following year's Jan. 15 unless one of those dates falls on a weekend or federal holiday. Then the estimated tax deadline is the next business day.

The table below explains what earning periods are covered by these so-called quarterly payments. Yes, the Internal Revenue Code plays fast and loose with another standard definition.

Payment # Due Date For income received
1 April 15 Jan. 1 through March 31
2 June 15 April 1 through May 31
3 Sept. 15 June 1 through Aug. 31
4 Jan. 15
(of the next year)
Sept. 1 through Dec. 31

And today's Daily Tax Tip also provides the skinny on estimated taxes.

Figuring your untaxed earnings: Basically, at the beginning of each year, the IRS wants you to make a good guesstimate of how much untaxed money you'll get -- for example, from investment income or self-employment earnings -- you'll get in the next 12 months and then divide that amount by four. Then you make a payment of that amount each estimated tax due date.

If it turns out you made more in the first three months of the tax year than you expected, your first quarterly payment could be too little. And you could face an underpayment charge for the smaller than required estimated payment.

And no, you can't simply put off your full estimated tax payment until the final January one (a key January tax deadline noted in yesterday's Daily Tax Tip). That will get you in even more late tax payment trouble since you received some of that income months ago.

When you file, the IRS calculates how much tax you should have paid each quarter and then figures the penalty amount for each quarter. All the quarterly penalty amounts are added up to arrive at your overall estimated tax underpayment penalty.

Avoiding underpayment penalties: There are, however, several ways to avoid these possible penalties.

You can meet one of two safe-harbor payment thresholds. Here, the IRS says you won't owe any underpayment penalty if the total of your withholding and timely paid (that focus on deadlines again) estimated tax payments were at least the smaller of:

  • 90 percent of your current year's eventual tax bill or
  • 100 percent of your prior tax year's tax liability.

For most of us, using the 100 percent safe harbor is easier because we know what we owed last year. So we make sure we pay combined estimated taxes and any withheld taxes -- say, from a spouse with whom you file a joint return -- that are at least as much as what we owed last year.

If you're wealthier -- the tax definition of rich here is adjusted gross income of more than $150,000 for married couples filing jointly and single taxpayers or $75,000 for married taxpayers filing separately -- then you must make estimated/withholding payments that are 110 percent of your prior tax bill.

Or you can do some extra tax-filing work.

Filing more forms: If you do get wildly divergent amounts of untaxed income throughout the year, it might be worthwhile to file Form 2210. Here you explain why you didn't pay four equal amounts of estimated tax during the year.

This is known as annualized income estimated tax method. It's effective, for example, for folks whose earnings are seasonal, such as a lawn work where you have more spring and summer clients. It also is an issue for folks who get unexpected earnings from their investments at the end of a tax year.

In these cases, you use Form 2210 to figure your estimated tax payment for each of the four payment periods. It's not easy. You must claim all your income and apply the appropriate deductions in the proper tax quarter. 

Tax software can help, but it still requires a lot of work on your part to determine the earnings periods of the untaxed money. The annualized income system of estimated tax payments, however, is a truer representation of your income in each quarter.

And it could help reduce any estimated tax penalty.

You also might find these items of interest:


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Brian Huber

This post will aid my new tax students in understanding the basic distinction of the estimated tax penalty from that other penalty for failure to pay the entire tax liability by April 15. You provide a fine overview of the safe harbor and deliver a correct warning that Form 2210 is one of the more complicated tax matters covered in Enrolled Agent exam study at Mastering that form, however, is crucial for tax pros helping people who received unexpected windfalls in one quarter of the preceding year. I strongly recommend that any taxpayer with this situation seek professional assistance from an Enrolled Agent. That’s also a reason for novice tax preparers to become Enrolled Agents who can conquer complicated issues and forms such as those concerning the 2210 penalty.

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