Estimated tax payments are periodic advance payments of taxes owed on income that is not subject to withholding. This includes, but is not limited to, self-employment income, interest, dividends, alimony, rent, and gains from the sale of assets.
The IRS requires taxpayers to make these payments if they expect to owe at least $1,000 in tax for the year, after subtracting their withholding and refundable credits.
Importance of Estimated Tax Payments:
The U.S. tax system operates on a “pay-as-you-go” basis, meaning taxes must be paid as income is earned or received throughout the year. Failure to pay enough tax during the year can result in penalties, even if you are due a refund when you file your tax return.
Avoiding Underpayment Penalties:
To avoid underpayment penalties, taxpayers must meet one of the following criteria:
- Pay at least 90% of the tax for the current year: This involves making sure that your estimated tax payments throughout the year, along with any withholding, equal at least 90% of your current year’s tax liability.
- Pay 100% of the tax shown on your prior year’s return: If your adjusted gross income (AGI) was $150,000 or less ($75,000 if married filing separately), you must pay 100% of the tax shown on your prior year’s return. If your AGI was more than $150,000 ($75,000 if married filing separately), you must pay 110% of the tax shown on your prior year’s return.
If these thresholds are not met, the IRS may impose an underpayment penalty, which is calculated based on the amount of underpayment for each period and the interest rate determined by the IRS.
Example Scenarios Requiring Estimated Tax Payments
- Rental Property Income: If you receive rental income from property you own, this income is not subject to withholding. You must estimate the annual rental income, deduct any allowable expenses, and pay estimated taxes on the net rental income.
- Investment Income: Income from investments such as interest, dividends, and capital gains must also be considered. For example, if you have significant dividends from stocks or a large capital gain from selling an investment, this income must be reported, and taxes on these earnings must be paid quarterly through estimated tax payments.
- Retirement Account Distributions: Distributions from retirement accounts, such as IRAs and 401(k)s, can significantly impact your tax liability. If you take a distribution, especially a large one, and it does not have enough taxes withheld, you may need to make estimated tax payments to cover the shortfall.
Using Form W-4 to Adjust Withholding:
An alternative to making estimated tax payments is adjusting the amount of tax withheld from your paycheck. This can be done by submitting a new Form W-4 to your employer. The form allows you to request additional withholding, which can help cover income from other sources.
To adjust your withholding:
- Complete Form W-4: Provide your personal information and filing status. Use the “Multiple Jobs” worksheet if you have more than one job or are married filing jointly and both spouses work.
- Claim dependents: This affects your tax liability and the amount of withholding.
- Other Adjustments: Use the “Other Adjustments” section to specify additional withholding for income that is not subject to payroll tax withholding.
Example of Adjusting Withholding
- Suppose you have a rental property that generates $12,000 in net annual income.
- You can calculate the additional tax owed on this income and adjust your W-4 to withhold this amount from your regular paycheck.
- For instance, if your marginal tax rate is 24%, you would need an additional $2,880 withheld for the year ($12,000 x 24%).
- By dividing this amount by the number of pay periods remaining in the year, you can determine the additional withholding needed per pay period.
Conclusion
Estimated tax payments are a crucial part of tax planning for individuals with income not subject to withholding. Understanding when and how to make these payments can help you avoid underpayment penalties and comply with IRS regulations. By accurately estimating your tax liability and making timely payments or adjusting your withholding through Form W-4, you can manage your tax obligations effectively and avoid unnecessary penalties.
For detailed guidance and personalized tax planning, consulting with a tax professional is highly recommended. Mraz Tax Solutions can assist you with calculating estimated tax payments and projecting taxes owed, providing you with peace of mind and financial clarity throughout the year.
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