Estimated Taxes For The Self Employed And How To Avoid Them

I began tutoring in November of 2007 to supplement my income and boost savings towards my condo down payment. My 2007 income tax return only included two months of tutoring income, which was not long enough a period of time to worry about estimated taxes. In 2008 I will have a full year of self employed income, which will require me to make estimated tax payments, or will it?

Estimated Tax Payments

Estimated tax payments are required by the IRS if you expect yourself to owe the government more than $1,000 when you file your income tax return. Estimated tax payments are due using the following quarterly schedule:

  • 1st quarter due date – April 15
  • 2nd quarter due date – June 15
  • 3rd quarter due date – September 15
  • 4th quarter due date – January 15

Most of the time estimated tax payments are associated with self employed individuals. This is because self employed individuals don’t have taxes already withheld from their income. Under some circumstances a standard W-2 employee will have to worry about making estimated tax payments. This scenario occurs when an unusually large bonus is received,  irregular income is incurred from the sale of stocks or you manage to catch Barry Bonds’ record setting home run.

Penalties

In addition to paying the amount of taxes that hasn’t been paid, a penalty is assessed that is based on numerous factors and is paid along with the payment for the income tax return. An interest rate factor is used to determine the magnitude of the penalty. An interest rate factor is used because the government feels as though they missed out on income from interest. The last factor that weighs into the penalty is when the income should have been reported. If the taxes that are delinquent should have been paid in the first quarter’s estimated tax payment your penalty will be larger than if the taxes should have been paid in the third quarter’s estimated tax payment. IRS Form 2210 is used to calculate the fee.

Withholding from Wages

If you derive most of your income from standard employment, which withholds taxes from your wages (W-2), you may be able to avoid paying a penalty. As the end of the year approaches and you think you might be vulnerable to a penalty, you can ask your employer to withhold extra taxes on your last couple of pay stubs. To take advantage of this strategy you must talk with your employer and fill out a W-4 form. This is possible because wages from withholding are considered to be paid equally over all installments.

Safe Harbor Exception

The safe harbor exception stipulates that no estimated tax penalties will be incurred if the total tax payments (from estimated tax payments and withholding wages) for the year equal 100% of last year’s tax liability. This exception is possible if your AGI is less than $150,000. If your AGI is greater than $150,000 you will use a modified safe harbor exception. For AGIs greater than $150,000 the tax payments must equal a percentage greater than 100% of the previous year’s tax liability. To find this value read IRS publication 505.

Avoiding the Estimated Tax Penalty

Combining the safe harbor exception and the withholding extra wages trick you can successfully avoid paying estimated tax payments and the associated penalty. To do this make sure you withhold enough wages to stay under the $1,000 threshold or withhold enough wages to meet 100% of last year’s tax liability.

My Estimated Tax Payments

I have not been making estimated tax payments as I need the money for my down payment due in a week from tomorrow (WOOT). Additionally, I fully expect to fund a solo 401k with my self employed income, so I don’t expect my tax liability to increase at all. Also, I should have no problem qualifying for the safe harbor exception as my salary increased from my regular job and the wages withheld should have increased accordingly. I will be doing some quick calculations towards the end of the year to see if I do in fact qualify for the safe harbor exception and will file a W-4 if necessary. I encourage all of you self employed individuals to do the same.

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One Response to Estimated Taxes For The Self Employed And How To Avoid Them

  1. Ned Carey says:

    I have missed some estimated tax payments or been a little late and my accountant just figures in the penalty when I pay on the 15th.

    One thing you need to be careful of however, if you pay estimated based on last years taxes and you have a significant increase, you need to make sure you have enough money on the 15th. If you haven’t put money aside you may be stuck come tax time the following year.

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