2020 was quite the year and it turned some people’s financial houses upside down. If you earned income from self-employment, received unemployment income, or took a COVID distribution from a retirement account without withholding income taxes, you may want to make an estimated payment. This will help you avoid potential and underpayment penalties and interest.
The fourth quarterly payment for 2020 is due January 15, 2021. Are you ready? If not, here’s just about everything you need to know about quarterly estimated taxes. If you want to dig deeper into the US tax code, you can read more about tax withholding and estimated tax in IRS Publication 505.
Who needs to pay estimated taxes?
If you’re employed by someone else, taxes are already withheld from your paychecks. But if you’re self-employed or an independent contractor (think Form 1099-NEC), you may owe estimated taxes.
First, you do not owe estimated taxes if you meet all three of the following requirements:
- You did not have a tax liability in the prior year (i.e., last year you owed $0 in taxes).
- You are a US citizen or resident for the whole year.
- Your prior tax year covered a 12-month period.
In most cases, you must pay estimated taxes for 2021 if both of the following apply.
- You expect to owe at least $1,000 in tax for 2021, after subtracting your withholdings (if any) and refundable credits. Refundable credits are things like the Earned Income Credit and Child Tax Credit.
- You expect your withholding and refundable credits to be less than the smaller of:
- 90% of the tax to be shown on your 2021 tax return, or
- 100% of the tax shown on your 2020 tax return. Use 110% if you have high income. Your 2020 tax return must cover all 12 months
Basically, you want your withholdings and refundable credits to cover at least 90% of what you owe this year or 100% of what you owed last year. If they don’t, and the difference is $1,000 or greater, you need to pay estimated taxes.
It’s important to take the time each quarter to evaluate whether or not you will owe estimated taxes, especially if your job situation changes throughout the year.
How much should I pay in estimated taxes?
If you’re self-employed, a quick estimated tax calculation is taking your business’s net income and multiplying that by 25%, which covers roughly 15% for self-employment taxes and 10% for the federal marginal income tax rate. You can also estimate your quarterly taxes using an accounting program like QuickBooks Self-Employed, this online self-employment tax calculator, or by working with your accountant (like me!).
The more detailed way is to complete Form 1040-ES with your prior year return and adjust for changes in the tax law, your sources of income, deductions, and/or your federal marginal income tax rate.
The IRS allows for two methods to calculate the amount you owe on Form 1040-ES.
- Regular Installment Method. This method assumes that all of your income for the year comes to you evenly and regularly throughout the year. You would calculate the taxes owed on your income and then pay one-fourth each quarter.
- Annualized Installment Method. This method assumes your income is earned unevenly throughout the year. Perhaps most of your sales occur during the holiday season. You may be able to lower or eliminate the amount of your required estimated tax payment using this method.
And don’t forget to save for and pay any applicable state and city income taxes, which could be another 5% to 10%.
How do I make quarterly estimated tax payments?
What are the due dates?
The 2021 federal quarterly estimated tax payments are due as follows:
- Quarter 1 (January 1, 2021 – March 31, 2021) is due April 15, 2021
- Quarter 2 (April 1, 2021 – May 31, 2021) is due June 15, 2021
- Quarter 3 (June 1, 2021 – August 31, 2021) is due September 15, 2021
- Quarter 4 (September 1, 2021 – December 31, 2021) is due January 15, 2022
If your state collects estimated taxes, be sure to check their website for their due dates!
What if I haven’t made any quarterly estimated tax payments?
As mentioned above, individuals who don’t pay or underpay their estimated taxes generally face a penalty unless the total amount of withholding and estimated tax payments is equal to the lesser of:
- 100% of your prior year tax liability, or
- 90% of your current year tax liability
Keep in mind that penalties are figured separately for each period, so you may owe for an underpayment in a prior period even if you paid enough later to “catch up” on the amount due. It’s very important to calculate the proper amount due each period and pay it on time!
If you receive your income unevenly throughout the year (for example, because you operate your business on a seasonal basis or you have a large capital gain late in the year), you may be able to lower or eliminate the amount of your required estimated tax payment and any penalty for one or more periods by using the annualized income installment method.
If you’re growing your business while still employed and have payroll taxes withheld from your paycheck, you also have the option to increase those tax withholdings. Or if you’re married and file your tax return jointly, your spouse could increase the tax withholdings on their payroll check to mitigate some of the estimated taxes you might have to pay on income earned through self-employment. Finally, there are some strategies like contributing to certain retirement accounts that will then lower your taxable income.
What else do I need to know?
Save, save, save! If you’re an entrepreneur, your income is most likely pre-tax dollars. That means when tax time rolls around, you are responsible for your personal income taxes and self-employment taxes (Social Security and Medicare taxes). Therefore, it’s extremely important to set aside your tax dollars with each paycheck.
As for where to save your money, I recommend opening a separate bank account just for your taxes so you won’t be tempted to tap into them. FDIC-insured online banks like CapitalOne 360 or Ally Bank have no minimums or fees. Additionally, they offer a higher yield than traditional savings accounts.
There’s also a great app call Qapital that will automatically transfer a portion of client payments to a separate savings account for taxes. Once it’s time to pay your estimated taxes, simply withdraw the necessary funds from that account.
Of course, there are many nuances and exceptions to the US tax code, so refer to Publication 505 for more details or discuss your individual tax situation with your tax preparer. For example, there are special rules for farmers, fishermen, certain household employers, and certain higher-income taxpayers not addressed here.
If you have questions about estimated taxes or would like a CPA to run the numbers for you, click the link to get in touch!