I was recently asked how to know if estimated tax payments are necessary. Let’s start with a simple explanation of what estimated tax payments are. The IRS likes to receive money on a regular basis and therefore if you wait to pay them a large chunk until April, chances are you will owe them a penalty and interest. The IRS takes what you owe at year end and divides it into quarters and calculates a penalty and interest based on what you should have paid for each quarter. In order to avoid penalties and interest you make quarterly estimated payments. The trick is how do you know when you should make them.
Here are some common instances when people need to make estimated payments.
- If you are self employed and not in an S Corp where you have to take wages and pay payroll taxes, then you’ll need to make estimated tax payments
- If you are self employed and in an S Corp but the wages you pay yourself do not cover your full tax liability you will need to make estimated payments
- If you earn income from sources other than wages, such you own rentals, you will need to make estimated payments
- If you receive distributions from taxable pensions or annuities and nothing is withheld, you will need to make estimated payments.
The even trickier part is to determine how much each payment should be. There are several methods to consider. Your tax preparer should provide estimated coupons for the next year when they prepare your return and discuss with you why they chose the amount they did.