All US individual taxpayers are subject to the estimated tax rules. However, most individual taxpayers do not make quarterly estimated tax payments because the withholding on their wages is sufficient to meet their quarterly tax requirements. So, although all individuals are subject to the estimated tax rules very few are aware of it until they have received a penalty notice for underpayment of estimated tax from the IRS. Here’s how to stay safe.
During the calendar year, individual taxpayers are required to pay a portion of their current year income tax to the IRS via tax withholding or by making estimated tax payments or by a combination of withholding and estimated tax payments. Since taxpayers do not know what their 2016 tax liability is until 2017, they are allowed to meet this estimated payment obligation based on either their current year tax or their prior year’s tax obligation. Taxpayers may base their estimated payments on whichever method results in the lowest estimated payment obligation (see example below).
Current Year Tax – Method 1
The first method is to pay 90% of your current year tax. This method is not a completely safe method. It requires that you estimate your current year income and calculate tax based on your estimate. If your estimate is incorrect, then you could be underpaid and subject to penalty.
Prior Year’s Tax – Method 2
If your prior year AGI is less than 150k – 100% of your prior year’s tax. This method is often referred to as a safe estimate since the prior year’s tax can be known with certainty (assuming you have filed your tax return by April 15th). The amount owed is simply a percentage of your prior year’s tax.
If your prior year AGI is 150k or more then you are required to pay 110% of your prior year’s tax across the four quarter in order to have a safe estimate.
Although estimated payments are referred to as “Quarterly” estimated payments, they are actually not based on 3, 6, 9, and 12 months of income. Instead, they are calculated and due as follows:
| Estimated Payment | Income thru | Due Date |
| 1st Quarter | March 31 – 3 months | April 15 |
| 2nd Quarter | May 31 – 5 months | June 15 |
| 3rd Quarter | Aug 31 – 8 months | September 15 |
| 4th Quarter | Dec 31 – 12 months | January 15 |
Taxpayers are allowed to use whichever method results in the lowest amount due each quarter but any prior quarters but the amount paid in must meet their cumulative quarterly obligation.
An Example
Let’s assume that Bartok, a single taxpayer, had AGI of less than 150k in 2016 and paid 20k in taxes. In 2017, Bartok decided to vacation in Europe from Jan 1 through March 31st. During this 3-month period, Bartok earned no income. Bartok’s 1st quarter estimated payment is equal to the lesser of: 90% of his 1st quarter tax liability (90% * 0 = 0) or 25% of his prior year’s tax liability (100% * 25% * 20,000 = $5,000). So, for the first quarter, Bartok is not required to make an estimated tax payment since he is allowed to pay the lesser of $0 (payment based on current year’s tax) or $5,000 (payment based on prior year’s tax).
Bartok returns to the US in April and works on a lucrative independent contractor job which earns him 75k of self-employment income. Bartok collects payment on his contract in May of 2016. Bartok’s annualized income would be $180k (75k ÷ 5*12) and the tax on $180k would be approximately 58k (including self-employment tax). Based on this calculation of his current year’s tax, Bartok would owe 26k ((58k*90%) ÷ 4 quarters * 2 quarters)) for his second quarter estimated tax payment. Under the prior year’s tax method, Bartok would owe only 10k in estimated taxes (20k prior year tax * 2 quarters). Bartok decides to pay only the required 10k (the lesser of the two calculations) knowing that he may need to make up the additional amount due when he files his tax return.
Bartok would continue to calculate his tax due each quarter. If Bartok earns no additional income during June, July and August (the only income he earned being the 75k he earned in May), then his 3rd quarter annualized income is 112.5k (would be (75k ÷ 8*12)) and the tax on the annualized income would be approximately 35k and the cumulative amount that should be paid through the first three quarters would be almost 24k ((35k * 90%) ÷ 4 quarteres * 3 quarters). Therefore, for the third quarter a payment of 5k based on the prior year’s tax would again be the lesser amount and Bartok would make another $5k payment.
Finally, for the entire year the only amount earned is the 75k earned in May, then the annualized tax due is approximately 21k. Bartok makes a 4th quarter estimated tax payment of 5k and $1k is due on April 15th with the filing of his tax return.
| Tax Due Based on Prior Year Tax | Cum Due Based on Prior Year Tax | Annualized Tax Due Based on Current Year Tax | Cum Due Based on Current Year Tax | Qtrly Pmt Due |
Cum Paid |
|
| Q1 | 20k * 1/4 = | 5,000 | 0 * 1/4 = | 0 | 0 | 0 |
| Q2 | 20k * 2/4 = | 10,000 | 58k * 90% * 2/4 = | 26,100 | 10,000 | 10,000 |
| Q3 | 20k * 3/4 = | 15,000 | 35k * 90% * 3/4 = | 23,625 | 5,000 | 15,000 |
| Q4 | 20k * 4/4 = | 20,000 | 21k * 90% * 4/4 = | 18,900 | 3,900 | 18,900 |
Thus, Bartok made the wise decision to pay his 2nd quarter taxes based on the lesser of his prior year’s tax or his annualized income. Bartok was able to do this because his prior year tax was less than his estimated current year tax. By contrast, if Bartok’s prior year tax had been 40k, then the payments made by Bartok (assuming Bartok earned only 75k in May of 2016)
| Tax Due Based on Prior Year Tax | Cum Due Based on Prior Year Tax | Annualized Tax Due Based on Current Year Tax | Cum Due Based on Current Year Tax | Qtrly Pmt Due |
Cum Paid |
|
| Q1 | 40k * 1/4 = | 10,000 | 0 * 1/4 = | 0 | 0 | 0 |
| Q2 | 40k * 2/4 = | 20,000 | 58k * 90% * 2/4 = | 26,100 | 20,000 | 20,000 |
| Q3 | 40k * 3/4 = | 30,000 | 35k * 90% * 3/4 = | 23,625 | 3,625 | 23,625 |
| Q4 | 40k * 4/4 = | 40,000 | 21k * 90% * 4/4 = | 18,900 | 0 | 23,625 |
Thus, in a case where Bartok’s prior year tax is greater than his current year tax, the amount paid in is actually greater than the eventual tax due.
Making the Payment
The payments can be made by mailing a check with a 1040 ES voucher to the IRS or you can make them online through the IRS website at https://www.irs.gov/payments/direct-pay
Simple Idea – Complicated in Practice
The idea of estimated payments is pretty simple. You determine your tax based on a couple of rules and then you pay it in over 4 quarters. However, it can get a lot more complicated. The important thing is to know that if you have income and you don’t have withholding to cover the taxes on that income, you should contact your CPA to make sure you know what you owe and when.
[…] as a result of that payment, you may need to make an estimated tax payment (see other post here) to avoid or mitigate underpayment […]