By Cathy Peters
The IRS generally requires you to pay your tax as you earn or receive income and pay your tax liability over the course of the year rather than waiting until you file your return on April 15th. Most people meet this requirement without really thinking about it because tax is withheld from their wages by their employer. But if you are self employed or have significant amounts of other income such as interest, dividends, capital gains, rents and royalties, or income from pass-thru entities that are not subject to Federal withholding, you may be required to make quarterly estimated tax payments. Estimated tax payments may also be required for other types of tax such as self-employment tax, household employee’s tax, and alternative minimum tax. Penalties may be assessed for failure to make estimated tax payments or failure to have adequate withholding from your wages.
The law provides “safe harbors” for avoiding the estimated tax penalty. No penalties are assessed if your annual timely payments are equal to:
- 90% of the current year’s tax liability, or
- 100% of the prior year’s tax liability if your prior year’s adjusted gross income was less than $150,000, or
- 110% of the prior year’s tax liability if your prior year’s adjusted gross income was over $150,000
The penalty can also be avoided if you make payments based on annualized income when your income is not earned evenly throughout the year, i.e. a large sale of stock or other asset.
If you are an employee and required to make estimated tax payments, you can avoid the process by increasing your withholding with your employer. Federal withholding is considered as paid equally throughout the year, even if it is not.
It’s best to avoid the penalty with one of the safe harbors, but if you do have an underpayment subject to a penalty, it is equivalent to interest on the amount of the underpayment. Please let us know if you need assistance in determining necessary withholding or estimated payments.
There will be a Part 2 later this week on changes during 2013 that could affect your calculations of estimated tax or adequate withholding.