Mistakes can be costly if left unchecked
For many people, income tax withholding is something that happens automatically: you indicate your tax withholding rate to your employer on a W-4 form for federal taxes and a DE 4 form for California, and the taxes are taken out before you even see your paycheck. If your employer withholds at the correct rate, chance are you’ll end up with a nice refund at tax time.
There are other types of income, however, which are also subject to tax. For this income, you need to estimate and pay the tax yourself. Getting the estimation right is very important, because underpayment comes with consequences.
Mistakes can be costly, with penalties and fees that can add up quickly. Understanding how to do the calculations, how to make your payments correctly, and what is required to stay compliant can save you from unpleasant surprises. Estimated tax payments apply to both federal and state income tax, and there are. Here is what you need to know.
An overview of estimated taxes: who has to pay?
The way the U.S. tax system works, you are generally required to pay tax on your income as you earn it. In an employment situation, this is taken care of through withholding, but if you are self-employed or if you receive income from other sources such as investment dividends, gains from stock or other interest, rent or alimony, it’s up to you to make regular tax payments yourself. If you are employed, you may be able to avoid making estimated tax payments by asking your employer to withhold taxes at a higher rate. Otherwise, you can determine whether you need to pay federal estimated tax by answering these questions:
- Are you a U.S. citizen or resident alien or a resident of Puerto Rico, the U.S. Virgin Islands, Guam, the Commonwealth of the Northern Mariana Islands, or American Samoa; or a Nonresident alien?
- Do you expect to owe more than $1,000 in taxes for the tax year after subtracting your federal income tax withholding from your total expected amount of tax?
- Do you expect your federal income tax withholding (plus any estimated taxes paid on time) to add up to less than the smaller of: 90% of the tax that you will owe for this tax year or less than 100% of the previous tax year?
If you answer “yes” to all of these questions then you are probably required to make estimated tax payments.
For the state of California, the threshold is lower: you will probably need to makes estimated payments if the following statements are true:
- You expect to owe more than $500
- You expect your expect your state withholding and credits to be less than the smaller of: 90% of the tax shown on this year’s tax return; or 100% of the tax shown on your last year’s tax return including Alternative Minimum Tax (AMT).
There are some exceptions, which will be discussed later in this article. These payments are generally made on a quarterly basis. The dates of the payments are predetermined each year, but the amount of the payments must be carefully calculated each year.
Calculating your estimated tax
For both federal and California state income taxes, you will use the last year’s tax return to determine how much to pay in estimated tax.
For federal taxes:
The safest estimation you can make is 100% of the last year’s tax liability, unless your adjusted gross income last year was more than $150,000 (or $75,000 for those who are married and filing separate returns last year.)
In that case you should pay 110%. Paying these minimums will mean that you won’t have to pay an estimated tax penalty, even if you end up owing more on your tax return at the end of the year.
If you have reason to think that you will be earning less this year than you did last year, you can choose to pay 90% of last year’s tax liability. If you turn out to owe more, however, you could end up paying a penalty.
You can also figure out a more exact estimate by looking at your expected gross income, taxable income, taxes, deductions, and credits. Last year’s return is a good starting point.
For your federal taxes, if you are filing as an individual (ie: sole proprietor, partner, S corporation shareholder and/or a self-employed individual) you will use IRS Form 1040 ES to calculate your estimated taxes. Here is the 2016 form, to give you an idea of how it works. If you are filing as a corporation, you will need to use IRS Form 1120 W.
For California taxes:
California requires you to pay your estimated tax in installments, which total either 100 percent of your last year's tax or 90 percent of your current year's tax. If your adjusted gross income last year was more than $150,000 (or $75,000 for those who are married and filing separate returns last year) then you will need to pay estimated tax of 90% of last year’s taxes or 110% of the year before.
You will use FTB Form 540-ES to work out your payments.
Making your estimated tax payments
For both federal and California state taxes, you will need to make 4 quarterly payments. The due dates for both are the same, but the percentages due for each payment are different for the IRS and the FTB.The quarterly due dates are:
- For the period of Jan. 1 to March 31: April 18
- For the period of April 1 to May 31: June 15
- For the period of June 1 to Aug 31: Sept. 15
- For the period of Sept 1 to Dec 31: Jan. 17, next year
For federal taxes
There are two methods for figuring how much you owe for each period.
If your income is more or less the same throughout the year, you should use the Regular Installment Method, where you simply divide your annual estimated tax by 4.
If your income varies throughout the year, with big fluctuations in slow and busy periods, you should use the Annualized Income Installment Method. To calculate quarterly payments with this method, you will need to use the IRS worksheets 2.9.
You can pay your federal estimated taxes online using the Electronic Federal Tax Payment System (EFTPS). You can split each quarterly payment into smaller weekly, biweekly or monthly payments if you like, as long as you have paid the full amount by each quarterly due date.
For California state taxes:
California has set percentages for each quarter. They are:
30% First quarter (April 18)
40% Second quarter (June 15)
0% Third quarter (September 15)
30% Fourth quarter (January 17)
You can pay your estimated taxes online using the FTB Web Payment portal.
All about Underpayment Penalties
Underpayment penalties can happen if you do not make the full estimated payment for each quarterly period. The penalties occur when you file your income tax return.
Form 2210 and calculating your federal underpayment penalty
The first page of IRS Form 2210 has a flowchart to help you determine whether or not you must file the form with the IRS. Even if you don’t need to file the form, you can still use it to figure out how much penalty you owe.
The amount of an underpayment penalty is very difficult to calculate. The rates change from year to year and the method of calculation is quite complicated. The instructions IRS Form 2210 lists the steps for calculating the amount of your penalty.
To save yourself a headache, you also have the option of letting the IRS figure the penalty for you, and if you pay the full amount by the due date on the bill, it won’t cost you anything extra. Here’s how it works:
- The IRS will use your return to calculate how much tax you should have paid each quarter.
- The IRS will then apply a penalty rate percentage to figure your penalty amount for each quarter.
- All the penalty amounts for each quarter are added up to arrive at the underpayment penalty you owe.
Form 5805 and calculating your California state underpayment penalty
The FTB Form 5805 is analogous to the IRS Form 2210, and while the FTB penalty rates may be different, the way that the underpayment penalty is figured is similar, and you also have the option for letting the FTB calculate your penalty for you.
Exceptions, special circumstances, and getting the penalty waived
If you owe less than $1,000 to the IRS or $500 to the FTB after subtracting your withholdings, estimated payments and tax credits, you will not be charged an underpayment penalty.
If you did not have any income tax liability for the previous year, you will not be charged an underpayment penalty.
Both the IRS and the FTB have special rules for farmers and fishermen. If your withholding plus quarterly estimated tax payments equal least 66.67% of your last year’s tax liability, you will not be charged an underpayment penalty.
You can file form 2210 to request a waiver under certain circumstances, for instance if your filing status changed from single to married or vice versa, if you applied a large overpayment to this year’s taxes from last year’s return, or if you generated a large part of your income late in the year. Form 2210 can also be used:
- If you are retired or disabled and you can prove that your underpayment was due to some other reason than willful neglect, you may attach a statement with your tax return explaining the reason for your underpayment and requesting that the penalty be waived.
- If you were the victim of a casualty or disaster which prevented you from making the estimated tax payments are required, you may also attach a note explaining your circumstances.
Avoiding underpayment penalties
Properly calculating your estimated taxes, making payments early, and paying at least 90% of your last year’s tax liability are the best ways to make sure you don’t get caught short and charged a penalty. The FTB even offers an email reminder service so that you never miss an estimated tax payment.
If you need more help with and would like to set up some time to consult with me, call my office, Brotman Law, at (619) 378-3138 today.