The following post is by MPFJ staff writer, Grayson Bell. Grayson, who runs the finance blog Debt Roundup, is a fan of personal finance, brewing beer, and working on cars.
This year I got a surprise when I finished up my taxes.
I owe quite a bit to the federal government. Why do I owe money? The answer for my situation is simple. I earned income on the side.
Anytime you earn income on the side of your regular job, you are required to pay taxes on it. The government wants their cut of everything that you make, so even if you get paid in cash, you are still supposed to report it. While I knew that I was going to make extra money last year, I didn’t realize how much. I could have avoided having to pay this year (plus any potential penalties) if I would have just properly estimated my taxes.
What Are Estimated Taxes?
Estimated taxes are payments that you make to the government to cover your tax liability on income not subject to withholding. A common form of this income would be earned through self-employment. Even though I am employed full-time, any extra income that I make on the side from freelancing and running a small business is considered self-employment income. Other applicable income includes interest, dividends, alimony, proceeds for the sale of assets, rent, and prizes/awards.
Anyone who believes they will owe more than $1,000 when taxes are due should be prepared to pay estimated taxes. If you had a tax liability for the previous year, then you might have to pay estimated taxes.
How to Calculate Estimated Taxes
It can be difficult to calculate how much you will need to pay for estimated taxes, but the IRS does have a calculation worksheet. They include it on their 1040-ES form. This form provides great detail into when you will have to pay and also helps you calculate how much you will owe. There are a few ways to calculate your estimated tax liability.
100% of previous year – If you owed more than $1,000 when you filed your return, then the safest way to deal with estimated taxes is to go with 100% of your previous years taxes. This would be to simply take what you owe to the federal government on your previous return and that would be what you need to pay. If your previous year’s adjusted gross income was more than $150,000, then you will need to go with 110%.
100% of current year – This number can be hard to know. You can use the IRS worksheet or software like TurboTax to help you calculate this number. If you are going to make the same salary, but can estimate how much you will make on the side this year, then this method can work. You use this calculation to ensure you don’t owe again on the next return. You do have the ability to change your calculation during the year, especially if your income fluctuates.
Avoiding a Penalty
If you don’t estimate your taxes properly, then you could owe a penalty. I had to pay one this year because I didn’t meet the criteria to have the penalty waived. This is an underpayment penalty. The penalty is currently an annual 4% of the amount you underpaid each period. This penalty can be avoided if your tax payments for the year exceed the lower of these two withholding scenarios:
- 90% of the current tax year minus credits
- 100% of the previous years tax (ie. You pay 100% of what you did in your last tax return or 110% if you make over $150,000)
You could also owe a penalty if you don’t pay your estimated taxes on time. If you are past their specified due dates, then you could be eligible for a penalty.
How to Pay Estimated Taxes
If you have your estimated taxes calculated, then it is important to understand how to pay them. The 1040-ES form comes with four payment vouchers. This allows you to split up your estimated tax liability into four payments. These can be equal or you can change the amounts depending on your calculated income. The IRS has strict payment deadlines. Here are the due dates for this current year.
1st Payment – Due on April 15th
2nd Payment – Due on June 16th
3rd Payment – Due on September 15th
4th Payment – Due on January 15th of the next year
If you want more in depth information about due dates and how you deal with them, then read more from the IRS estimated taxes section.
The IRS provides you with three ways to pay your estimated taxes. They are:
- Online – You can pay your estimated taxes online with a bank draft (e-check) or using a credit/debit card. The IRS has a site called the Electronic Federal Tax Payment System (EFTPS), which allows you to make your tax payments. Please note that will are charged a fee to use your credit and debit card. It is free to use the bank transfer option.
- Over the Phone – If you need to make your tax payment and you can’t get online, then you can call the EFTPS customer service line. If you want to pay by a bank transfer, then call 1-800-555-4477. If you want to pay with a credit or debit card, then you have to call one of the IRS’s payment providers. They are listed here.
- With Check and Voucher – This is going to be your slowest method. The four vouchers on the 1040-ES form will be used and you will need to mail your payment in to the nearest IRS office. There is a section on the 1040-ES form that tells you which office you need to mail your check to. The IRS does consider the postmarked date as when it was paid, not the date they receive it.
If you don’t want to deal with paying the tax on your own, then you can have your employer withhold more on your regular paychecks. This only works if you are receiving paychecks. You would need to resubmit an adjusted W-4 to your employer requesting that they withhold more than they normally do. You will still need to make sure they are withholding enough so you don’t owe when you complete your return.
Do it Yourself or Hire an Accountant?
The debate continues on whether you should deal with taxes yourself or hire an accountant.
I have used TurboTax for years and it makes my taxes easy. It even helped me calculate the estimated tax payments for this year. That being said, I believe next year will be time to hire an accountant. We are selling our home and buying another, along with me cashing in some stock options, and making more side income. This year’s taxes are going to be complicated and I want to make sure it is done right.
(A side note from Jacob: I was quite surprised how affordable an accountant can be. Some of the premium plans for online tax prep platforms can charge you around $90, whereas, some accountants cost less than $300 to prepare your taxes.)
If you don’t feel comfortable calculating your estimated taxes, then seek professional help. There is no need to get it wrong and have to pay a penalty just because you didn’t understand the calculations. If you are tax savvy and you can use the TurboTax or H&R Block software, then feel free. It will cost less than a tax accountant and give you a little more insight into how estimated taxes are done. Either way, feel comfortable with the option you choose and make sure you properly calculate and pay your estimated taxes.
How about you all? Do you have to pay estimated taxes for your income that is not taxed when it is paid? How do you pay your estimated taxes – online, via check, or on the phone?
Do you use an accountant to file your taxes?
Share your experiences by commenting below!
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