You most likely think you can skip this article. After all, you're probably not self-employed, so you don't need to worry about paying quarterly estimated taxes, right? Not necessarily.

Taxes aren't just meant to be paid on April 15. That's why we're blessed with tax withholding; it ensures that Uncle Sam is collecting revenue all year long. When this doesn't happen -- with self-employed citizens, for example, or investors with sizable dividend income or capital gains -- the IRS expects taxes on this income to be coughed up during the year. If your withheld taxes don't represent at least 90% of the taxes you actually owe for the current year, the IRS requires you to file quarterly estimates.

You might be thinking, "Gee, I never heard of this, and never worried about it, and nothing has ever happened, so I'm probably OK." Actually, it only means that you've been lucky thus far. Neglecting your estimated taxes puts you at risk for a hefty penalty. The IRS won't remind you of your responsibilities -- but it's only too happy to hand you a bill if you goof up.

The four exemptions
You can generally avoid paying estimated taxes if you meet one of the following conditions:

  • Your total tax balance due is less than $1,000
  • Your withheld taxes for 2005 are at least 90% of your total tax liability for the year
  • Your 2004 Adjusted Gross Income (AGI) was $150,000 or less, and your 2005 total taxes withheld are at least as much as your 2004 total tax liability
  • Your 2004 AGI was greater than $150,000, and your 2005 withholdings amount to at least 110% of your total 2004 tax liability.

Taxes are due in April, June, September, and January of each year. You can figure your total tax bill by taking all the taxes you owe and subtracting all the credits you have; you'll then have to divide that number into four chunks for quarterly payment. The taxes are filed with 1040-ES forms, available from the IRS and sometimes at your local library or post office.

Remember that if your income spikes upward early in the year, you can't put off paying estimated taxes until a later quarter. Each quarter is treated independently.

If you experience a major unexpected loss during the year and have already paid some estimated taxes, you're not entitled to a refund until you actually file your return. This could be nearly a year away, so if your financial situation is shaky, you might consider not paying estimated taxes and risking the penalty in order to keep your cash flow under control.

Loopholes to remember
If this is the first year that your income has increased substantially, you won't necessarily have to pay estimated taxes. You might be able to pay the entire balance due on April 15, without penalty, by using the so-called "exception No. 1." Essentially, if your current year's withholding is at least as much as your previous year's total tax (assuming that your AGI for the prior year is $150,000 or less), you can ignore any increases in 2005 income and pay any balance you owe in your April 15 tax return.

If you can't get out of paying estimated taxes, there's a convenience you need to know about: the "safe harbor." For the average person, this means that as long as you pay 100% of your previous year's total tax liability in withholding and/or estimated taxes, you'll be free from any penalty for underpayment of estimated tax, no matter what the current year's taxes end up being.

For example...
Here's how it works. Suppose that Pam's 2004 AGI was less than $150,000. Additionally, her total 2004 tax liability amounted to $13,500. In 2005, Pam sold some rental property for a hefty profit. She estimates that her taxes will amount to about $32,500 in 2005. Pam looks at her most recent check stub for 2005 and sees that she already has $13,750 withheld in federal taxes. Will Pam have to pay estimated taxes on her property sale in order to avoid penalties on her balance due?

Nope. Because her 2005 withholding ($13,750) is greater than her 2004 total tax liability ($13,500) and her 2004 AGI was less than $150,000, Pam can simply wait and pay her balance due when she files her 2006 tax return. She won't incur any additional penalties or interest on that large balance due.

However, if Pam's 2004 AGI were greater than $150,000, then she'd have to make sure that her 2005 withholding was at least 110% of her 2004 total tax liability. Using the example above, Pam's withholding for 2005 would have to be at least $14,850 (110% of $13,500) in order to avoid any underpayment penalties.

When your income is rising, the safe harbor is a wonderful way to avoid paying estimated taxes or prepaying any sizable tax burdens.

Declining income
When your income drops (after a year with extraordinarily large gains, for example), you may have a bit of a problem. If your normal withholding will cover your total tax liability for the year, you've got no worries. But what if it doesn't?

What if there's nothing you can do to get enough withholding? Or what if you're retired and don't have any withholding from wages or pensions? If that's your situation, you don't have any safety net. You'll be required to pay, at least quarterly, a minimum of 90% of your taxes for that period. You'll basically be preparing "mini" tax return each quarter, basing your estimated tax payments on the results of your tax computations. It's a pain, but it may have to be done to avoid the penalty.

You might say to yourself, "Heck, I'll just pay in 100% of my last year's taxes and not deal with these stupid quarterly computations." But if your 2004 total tax liability was $75,000, and you expect your 2005 total tax liability to only total $15,000, do you really want to overpay your taxes by $60,000 simply to avoid some computations? It's probably best to just bite the bullet and file your quarterly estimates.

On the other hand, if you have a pretty good handle on your total tax liability for 2005, you can simply divide that amount by four and send those payments in for your quarterly tax payments. It's not the best way to go -- you're still making some unnecessary overpayments -- but it's quick and easy. Just make sure that your estimate remains valid as the year goes on. If your total tax liability is greater than you originally thought, you'll have to make some changes in your quarterly estimated taxes down the road in order to stay penalty-free, which will require some computations.

It's a fine line. You don't want to pay too much, but you don't want to pay too little and risk a penalty. You'll have to keep an eye on your estimates all year. To learn more about estimated taxes, head over to IRS Publication 505, "Tax Withholding and Estimated Tax". For a different view of the same issues, check out Form 1040-ES and the associated instructions. High-income taxpayers especially need to fully understand the safe-harbor computations and percentages, and the special rules that apply.

Roy Lewis is currently reviewing various educational issues in order to change his life path. But he still understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.