Paying taxes can be a stressful experience for many individuals, especially if they find themselves facing a significant tax bill when filing their income tax returns. To avoid such surprises and potential underpayment penalties, it’s essential to understand how estimated income taxes work and the different methods available for paying them throughout the year.

In this blog post, we will explore the concept of pay-as-you-go taxes, the two primary ways to pay taxes, and the importance of making estimated tax payments, particularly for individual taxpayers.

 

What are “Pay-As-You-Go” Taxes?

The term pay as you go refers to a method by which individuals pay their income taxes throughout the year instead of waiting until they file their returns in the following year (April, unless the returns are extended until October). This system aims to prevent individuals from facing a large tax burden when filing their returns. This is done through income tax withholding or quarterly estimated income tax payments.

 

Understanding the “Safe Harbor” Tax Rule: Avoiding Underpayment Penalties

The safe harbor tax rule is a provision designed to protect taxpayers from penalties related to underpayment. To avoid such penalties, the IRS outlines specific conditions that must be met when making estimated tax payments:

  • If your tax owed for the current year, after accounting for withholdings and credits, is less than $1,000.
  • If you pay at least 90% of your tax obligation for the current year.
  • If you pay an amount equal to 100% of your taxes for the prior year (adjusted gross income (AGI) over $150,000 requires 110%).

Most states adhere to the federal safe harbor rules, but some have their own specific conditions.  For example, in California, individuals with an AGI of $1,000,000 or more must pay 90% of the current year’s tax to avoid a penalty (i.e. the “safe harbor” rule cannot be relied upon). When the current year AGI exceeds $150,000 but is less than $1,000,000, California individuals must pay 110% of the prior year’s amount to avoid the penalty. 

 

Choosing Your Tax Payment Approach: Withholding vs. Quarterly Estimated Payments

 

Understanding and Adjusting Your Tax Withholding

Income tax withholding is the most common method used by employees, pensioners, and individuals receiving certain government payments like Social Security. Employers deduct a portion of income taxes from their employees’ paychecks and send it directly to the IRS and state taxing authorities. Similarly, pensioners and government beneficiaries may have taxes withheld from their income.

How to Adjust Your Tax Withholding

Individuals experiencing significant life changes or earning income from various sources should regularly check and adjust their income tax withholdings to match their income tax obligations accurately. The IRS  Form W-4 allows employees to update their withholding, while the Tax Withholding Estimator can help calculate the appropriate amount.

Quarterly Estimated Tax Payments

For individuals who do not have income taxes withheld or who have additional income sources not subject to withholding, such as self-employment income, income from the sharing economy (e.g., ridesharing, rentals, etc.), or investment income (interest, dividends, capital gains), quarterly estimated income tax payments are essential to avoid underpayment penalties. These individuals need to calculate their estimated income tax liability and make installment payments throughout the year.

Making Estimated Tax Payments

Estimated tax payments are due each quarter throughout the year on the following dates:

  • Quarter 1: April 15, for income from January 1-March 31
  • Quarter 2: June 15, for income from April 1-May 31
  • Quarter 3: September 15, for income from June 1-August 31
  • Quarter 4: January 15 of the following year, for income through December 31

For federal income tax purposes, 25% of the calculated estimated income taxes must be paid quarterly, however states may not follow this same formula.  For example, California requires calculated estimated income taxes to be paid in 30% for quarter 1, 40% for quarter 2, 0% for quarter 3, and 30% for quarter 4.

Note: If these due dates fall on a weekend or legal holiday, the payments are due the next business day.

 

Federal Payment Options

Taxpayers have two primary options for making estimated tax payments:

  • Mail estimated tax payments with Form 1040-ES
  • Using IRS online payment options, such as Direct Pay, which allows payments from bank accounts, debit or credit cards, or digital wallets like PayPal.

You’ll need to confirm your identity before making a payment using Direct Pay options. Make a payment or schedule a payment, without signing up for an IRS Online Account. Pay from your bank account, your Debit or Credit Card, or even with digital wallet.

IRS2Go, the official mobile app of the IRS, offers convenient payment options and is available in both English and Spanish, making it easier for taxpayers to manage their taxes.

 

State of California Payment Options

If you expect to owe over $500 (or $250 for married filing separately), you must make estimated tax payments throughout the year. These payments must be made on time to avoid penalties and fees.

  • Mail estimated tax payments with Form 540-ES
  • Web Pay– Use Web Pay to pay with your checking or savings account for free.  Note, California law requires you to e-pay all future payments once the tax liability on the return exceeds $80,000 or if any payment submitted (by any means) exceeds $20,000.
  • California Franchise Tax Board uses ACI Payments (formerly Official Payments) to process credit card payments. 

Understanding the importance of pay-as-you-go taxes and the two methods for paying taxes throughout the year is crucial to avoid unexpected tax liabilities and penalties. Withholding from income and making quarterly estimated tax payments are both effective ways to stay ahead of tax obligations. Regularly reviewing and adjusting your tax payments based on changing circumstances will help ensure a smooth tax season and financial security.

Reach out to a member of our team if you have any significant life changes or income changes and would like to run a projection to estimate your tax liability.

 

 

Aura Advisors is a boutique tax consulting and compliance firm working with start-ups, emerging growth companies, and affluent individuals. Making it safer for good people and good companies to continue to do good things.