Why Pay Estimates?The tax system is intended to be a “pay-as-you-go” system, and the only way to prepay taxes is through withholding and estimated taxes. Generally, payroll comes to mind when we think about withholding, but withholding is also available through a variety of other means, including pension income and Social Security payments. However, there are a multitude of income sources that generally do not have withholding, such as self-employment income, interest, dividends, rents, gains from stock sales, alimony etc. Estimated tax payments provide a means of prepaying one’s taxes on these kinds of income. However, the use of estimated tax vouchers is not limited to taxpayers with income not subject to withholding. A variety of situations might arise that warrant the use of estimated taxes, such as taxpayers who are paid by commissions or who receive bonuses that distort their income. Frequently, a married couple with substantial income may also rely on estimated taxes to supplement its wage withholding. Are Estimates Mandatory?No, it is not mandatory for you to make estimated tax payments. However, if you end up owing money when you file your tax return, then you might be subject to the underpayment of estimated tax penalty. Unless you meet one of the exceptions explained later, this penalty could apply even if all of your income sources are subject to withholding. What is the Penalty?It is a nondeductible interest penalty computed on a quarterly basis. The interest rate varies from quarter to quarter based on the prevailing interest rates. Over the past 8 to 10 years, the rates have been as high as 8%, but most recently have been 5% or 6%. Estimate Due DatesPayments are due on the 15th day after the end of the quarter, giving a taxpayer 15 days to compute their tax liability for the prior period. The tax quarters are not all the same duration. The first quarter is three months (Jan–Mar), The second quarter is two months (Apr–May), The third quarter is three months (June–Aug), and The final quarter is four months (Sep–Dec). The due dates are: If paid all at once, the due date is April 15. If paid in installments, the due dates are: First payment: April 15 of the tax year Second payment: June 15 of the tax year Third payment: Sept. 15 of the tax year Fourth payment: Jan. 15 of the following year; or if the tax return is filed by Jan. 31 of the following year and the entire balance is paid with the return, the Jan. 15 payment may be skipped. Note: If a due date falls on a Saturday, Sunday, or federal legal holiday, the due date will be the next business day. The payment in January of the following year confuses some taxpayers who attempt to take credit for payment in the following year since that was the year in which it was paid. If you miss a payment due date, you should make the payment as soon as possible! Farmers and Fishermen Exception - With at least two thirds of their gross income for the prior year or the current year from farming or fishing, they may: Pay all of their estimated tax by Jan. 15 (fourth quarter due date); or File their tax return on or before March 1 and pay the total tax due. How to Avoid the PenaltyThere are a number of exceptions to the underpayment of estimated tax penalty, which can help you plan your estimated payments, avoid the penalty and minimize the advance payments. No Tax Liability In Prior Year - A taxpayer is exempt from the underpayment of estimated tax penalty if they had no tax liability in the prior year and they were a U.S. citizen or resident for the whole year. For this rule to apply, the tax year must have included all 12 months of the year. De Minimis Exception - Taxpayers can owe up to $1,000 on their tax return without penalty. Current Year Exception If a taxpayer’s withholding and estimated tax payments are equal to 90% or more of the current year’s tax liability, then there is no penalty. Prior Year Exception - The underpayment can also be avoided by prepaying through withholding and estimated tax payments an amount equal to 100% or more of the prior year’s tax liability. Caution: See High Income Taxpayers below. Prior Year Exception for High Income Taxpayers - For taxpayers with gross incomes (AGI) in excess of $150,000 ($75,000 for married taxpayers filing separately), the prepayments must total 110% of the prior year’s tax. This penalty exception is frequently used by taxpayers as means of determining a safe harbor estimate for the current tax year. Annualized Income Exception - A complicated exception can help you avoid the underpayment of estimated tax penalty if you have large changes in income, deductions, additional taxes, or credits that require you to start making or adjusting estimated tax payments. The payment amounts will vary based on your income, deductions, additional taxes, and credits for the months ending before each payment due date. As a result, this method may allow you to skip or lower the amount due for one or more payments. Farmers and Fishermen Exception - If at least two-thirds of the taxpayer’s gross income for the prior year or the current year is from farming or fishing, the taxpayer’s required annual payment is the smaller of: 66 2/3 % (.6667) of the total tax for the year, or 100% of the total tax shown on the prior year’s return, provided the prior year was for a full 12 months. Determining the Amount to PayIndividuals generally pay estimates in even quarterly amounts utilizing one of the underpayment exceptions or by projecting their taxes for the year. However, payments can be adjusted quarterly, allowing payments to be skipped or stopped if there are fluctuations in income significant enough to warrant the adjustment.