Paying Estimated Taxes
Self-employed workers must pay tax on the income earned or received during the year. Because the federal tax system is "pay-as-you-go," individuals must pay taxes on income through withholding or by paying estimated taxes. Employed individuals have taxes withheld from each paycheck, but self-employed individuals must make estimated tax payments throughout the year on income not subject to withholding. Paying estimated taxes goes towards both the federal income tax and self-employment tax.
Are You Self-Employed?
The IRS defines a self-employed individual as a person that:
- Has a trade or business as a sole proprietor or an independent contractor;
- Is a member of a partnership or limited liability company that carries on a trade or business; or
- Is in business for themselves, such as having a part-time business in addition to a regular job.
What is the Self-Employment Tax?
Self-employed individuals pay a self-employment tax (SE) on the net income earned from a business. Net income is the gross income after the deduction of allowable business expenses. The SE tax is a flat tax rate of 15.3%. The tax consists of 12.4% for Social Security and 2.9% for Medicare. The SE tax applies to all self-employed individuals regardless of income. However, earnings that exceed a certain amount ($106,800 in 2009) are not subject to the Social Security portion of the tax. In addition, a self-employed individual can deduct half of the SE tax from their adjusted gross income, which decreases the income tax.
Who Must Pay Estimated Taxes?
Estimated taxes pay for SE tax and income tax. Sole proprietors, partners, and S corporation shareholders must pay estimated taxes if they expect to owe a federal tax of $1,000 or more for the year. A corporation must make estimated tax payments if they expect to owe a federal tax of $500 or more for the year.
Who Does Not Have to Pay Estimated Taxes?
It is unnecessary to pay estimated taxes if:
- You had no tax liability in the previous year (you did not have to file a tax return or your tax liability was zero);
- You were not a U.S. citizen or resident for the entire year; and
- Your tax return in the previous year did not cover a full 12 months.
How to Calculate Estimated Taxes
The failure to pay enough estimated taxes may result in the assessment of IRS penalties. The easiest way to calculate estimated taxes for the current year is to use the tax return from the previous year. To avoid penalties, a taxpayer should make estimated tax payments that are at least equal to:
- 90% of the total tax liability for the current year; or
- 100% of the tax liability for the previous year (or 110% for high-income taxpayers).
When to Pay Estimated Taxes
The IRS divides the payment of estimated taxes into four installment periods. Each installment period has a coinciding due date for paying estimated taxes.
Income Earned During the Period
Estimated Tax Due
January 1 - March 31
April 1 - May 31
June 1 - August 31
September 1 - December 31
January 15 of the next year
The estimated tax on income earned during a period is due in its entirety by the installment due date or can be paid in installments. The IRS, however, does not require the payment of estimated taxes until a taxpayer has actually earned the income. If, for example, a taxpayer does not earn income during the first installment period, it is unnecessary to make an estimated tax payment during this period. When the taxpayer does earn income, the taxpayer must pay the entire estimated tax by the applicable due date for the period or may pay the estimated tax payment in installments.
How to Pay Estimate Taxes
Paying estimated taxes is simple. The IRS provides a taxpayer with several ways to make payments, including:
- Crediting an overpayment from the previous tax year to the estimated tax liability
- Sending in the payment with Form 1040-ES
- Paying by Electronic Funds Transfer when electronically filing a tax return
- Paying electronically through the Electronic Federal Tax Payment System (EFTPS)
- Paying by credit card over the phone or through the Internet
IRS Penalties for Underpaying Estimated Taxes
When a taxpayer underpays estimated taxes, the taxpayer may have to pay a penalty. The IRS may even charge an underpayment penalty if a taxpayer missed an installment payment or paid less than the amount required in an installment period. The IRS assesses a penalty based on a percentage -- ranging from 6% to 8% -- for each day the underpayment remained unpaid.