The Strange and Subtle Rules of Estimated Taxes
The IRS cautions freelancers and other self-employed individuals to stay on top of the deadlines for filing federal tax returns and the due dates for making payments. Miss just one, says the IRS, and it might exact a sizable, nondeductible penalty, which is based on the agency's current interest rate for back taxes.
Who must make estimated payments? The tax code mandates that individuals submit payments when their estimated tax exceeds $1,000, including any self-employment tax.
The IRS zeroes in on individuals with income from sources not subject to withholding of taxes. Mainly, they are:
- Freelancers and other self-employed persons who operate businesses or professions as sole proprietorships, in partnerships with others, or as independent contractors.
- Investors who receive interest, gains from sales of investment and the like
- Retired persons who don't have taxes withheld from pension payments or funds they remove from IRAs and other kinds of tax-deferred retirement plans.
Due dates for payments. For tax year 2014, the deadlines are April 15, June 15, and Sept. 15 of 2014; and Jan. 15 of 2015. However, the IRS allows individuals to skip January's payment, provided they submit their 2014 returns and pay their tax in full by Monday, Feb. 2 (the usual deadline of Feb.1 falls on a Sunday).
Part-time writers. You're not excused from making estimated payments just because you're a part-timer, as when you moonlight from your home as a writer and have a full-time job elsewhere. Want an IRS-approved way to avoid making those payments on the writing income? File a revised W-4 form with your employer and increase your income tax withholding from paychecks. This maneuver works only when 2014's withholding is enough to cover the taxes on your salary and on your writing.
Avoid unnecessary payments. Remember to take account of withholding during 2014 on what you or your spouse receive from salaries, wages, and other types of compensation. Also count an overpayment of taxes in 2013 that you elected to apply to your 2014 bill.
And be mindful that the IRS imposes penalties for failing to pay sufficient tax during the year through withholding or estimated payments, as well as for failure to pay required installments on time as they become due. It matters not that your final estimated payments are sufficient to erase any balance due when you submit 2014's Form 1040 in 2015.
Atone for an estimated tax shortfall with increased withholding from paychecks. Suppose you're in danger of being penalized for insufficient estimated payments throughout the year. Will the IRS forget about penalties for underpayments in the three previous quarters if you pay the shortfall through an increase in your last quarterly estimated payment? That won't work.
What does work is to make up the shortfall through increased withholding from wages (or from sources such as Social Security benefits, pensions, and IRA distributions) toward the end of the year. The IRS allocates withholding equally over each of the four payment periods. Consequently, boosting withholding can retroactively lessen or eliminate penalties when a similar increase in an estimated payment might not.
Take advantage of the "safe harbor" rules. Another IRS-blessed way to avoid penalties is to qualify under one of the "safe harbors" or exceptions. They excuse you from any penalties for underpayments of more than $1,000 for withheld or estimated taxes. (No penalties for underpayments of less than $1,000.) You're excused only if you satisfy a two-step requirement:
- You make payments by 2014's due dates.
- 2014's combined estimated and withheld taxes equal at least 90 percent of the actual taxes you owe for 2014 or 100 percent of 2013's total tax liability (line 61 of 2013's 1040 form)—whichever is the lesser figure.
The exception based on the prior year's tax is available even if the amount due was zero, provided the return covered 12 months, as it ordinarily would.
As the prior-year exception uses a fixed number, it's the easiest way for most individuals to figure their payments and dodge underpayment penalties. To illustrate, your payments total $12,000 for 2013 and $12,000 for 2014. With those kinds of numbers, you're home free, no matter how much you owe when you file for 2014.
Stricter rules apply when 2013's adjusted gross income (the amount on the last line of page one of Form 1040) exceeds $150,000 ($75,000 for married couples who file separate returns). To use the 100-percent escape hatch, payments must equal 90 percent of 2014's tax liability or 110 percent of 2013's total tax—again, whichever is less.
Another exception is available for someone who pays ninety percent of 2014's total tax, figured by "annualizing" income actually received by the end of the quarter in question.
The annualizing exception helps those whose incomes unexpectedly increase or fluctuate throughout the year, as when a freelance writer receives book royalties in December of 2014. But be warned: this calculation is complicated.
Help from the IRS. For detailed information, get a free copy of Publication 505, Tax Withholding and Estimated Tax.
About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Easy Tax Guide for Writers, Photographers, and Other Freelancers," available as a Kindle at Amazon.com and as a print copy at julianblocktaxexpert.com.