How to Calculate Your Quarterly Estimated Taxes
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If you're an employee, then your employer is responsible for withholding taxes from your wages before giving you what's left over as your paycheck. But if you're an independent contractor or business owner, then no one is withholding taxes for you. In that situation, the IRS doesn't want you to wait all year before paying your taxes. Instead, you're required to pay the year's taxes in four quarterly installments.
Of course, that creates two pretty significant problems for you. First, you need to have enough money on hand to pay the IRS on each quarterly due date. Second, you have to figure out how much you're supposed to pay each quarter -- which can get tricky if you don't know how much you're going to earn for the year to come.
Saving for the tax man
Solving the first problem is pretty simple: Every time you get paid, park at least 25% of it in a special savings account and don't touch it until tax time. That's your tax money to send to the IRS and possibly your state revenue board. You may find that you need to tinker with the percentage you save based on your quarterly tax bills; 25% is just a starting point.
There will almost certainly come a time when you will be tempted to tap into that money to pay for some crisis that rears its ugly head. Do not give in to this temptation. If you are unable to pay your federal taxes when the time comes, you will face enormous penalties and interest charges. And the IRS is downright terrifying about collecting its money; not even bankruptcy can save you from a federal tax debt.
Protecting yourself from underpayment penalties
The second problem is somewhat thornier. Some self-employed taxpayers are fortunate enough to have a steady paycheck, so they always know how much they'll be making in the months to come. But most small-business owners find that their income fluctuates to the point that it can get tricky to predict how much they'll make for the year, and therefore how much they'll owe in taxes. This is particularly true your first year in business, as you have no previous year's revenue to use as a basis.
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Fortunately, there's a hack you can use to be sure you won't be charged underpayment penalties by the IRS. You see, even if your quarterly payments end up being way less than you were supposed to pay, if they equal at least 100% of the previous year's tax liability, you won't be penalized for underpayment by the IRS. So if you want to be completely safe from underpayment penalties, look at the total taxes due on your previous year's Form 1040, divide the number by four, and pay that much in federal taxes at each quarterly due date (April 15, July 15, October 15, and January 15). You'll find the total taxes due figure on line 63 of the Form 1040, line 39 of the 1040A, or line 12 of the 1040-EZ.
Note that if your adjusted gross income for the previous year was more than $150,000 (or $75,000 if married filing separately), you have to pay 110% of the previous year's tax liability, not 100%, to avoid the penalty.
When you're required to make quarterly payments
Note that you don't have to start making quarterly payments until you have some income for the year for which you owe taxes. So if you start the year as an employee and then strike out on your own in the middle of the year, then that would be the point at which you would need to start paying estimated taxes for the year. Estimated taxes are required for anyone who expects to owe at least $1,000 to the IRS by the end of the year. If you don't cease being an employee until late in the year, you might not have that much tax to pay (aside from what your employer has already withheld), so you may not need to do estimated payments at all for that year.
Overpaying your taxes
If it turns out at the end of the year that you overpaid your taxes, you have a couple of options. First, if you realize you've already paid everything you owe for the year before your final quarterly payment is due on Jan. 15, then you can just skip the final payment. If you still have an overage at that point, or you don't catch the problem until after you've made that Jan. 15 payment, then you can either take the overpayment as a refund or apply it toward the next year's taxes -- or a combination of both. For example, if you discover that you overpaid your taxes for the year by $850, you could take back $400 of that as a refund and apply the remaining $450 to the next year's taxes. You make this selection on your Form 1040 when you file your tax return in April.
How to make estimated tax payments
You can make your estimated federal tax payments online, by phone, or by mail. In any case, you fill out Form 1040-ES to calculate how much you owe for the quarter. If in subsequent quarters you realize your calculation was too high or too low, you can fill out a new Form 1040-ES and use that figure for the remaining quarters.
Some states also require self-employed residents to make estimated tax payments of their state taxes, often using the same parameters as the IRS. Check with your state's department of revenue to find out whether you're required to make estimated tax payments and, if so, how they want you to send in the money.
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