Paying Estimated Taxes
And how to avoid it

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Roy Lewis
February 8, 2002

Are you tempted to just skip this article, thinking that you're not self-employed so you don't need to worry about paying quarterly estimated taxes? That wouldn't be a good idea. There are times in your life when, even if you're not self-employed, you might have to pay estimated taxes.

Taxes are meant to be paid throughout the year, not just on April 15. It's really a pay-as-you-go system. That's why we're blessed with tax withholding; it ensures that Uncle Sam is collecting revenue all year 'round. When this is not happening, as with the self-employed or investors with sizable dividend income or capital gains, the IRS expects taxes on this income to be coughed up during the year. To be precise, the IRS requires you to file quarterly estimated taxes if your withheld taxes won't represent at least 90% of the taxes you'll owe for the current year.

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." If so, it merely means that you've been lucky -- so far. Neglecting this means you may be hit with a penalty, and a sizable one, at that. It's up to you to attend to these things. The IRS won't be reminding you, except in the form of a penalty if you goof.

The bare bones
You can avoid paying estimated taxes if:

  • Your total tax balance due is less than $1,000.
  • Your withheld taxes for the current year are at least 90% of your total tax liability for the year.
  • For those with prior-year AGI of $150,000 or less, your current year's total taxes withheld are at least as much as your prior year's total tax liability.
  • For those with prior-year AGI of more than $150,000, your 2002 withholdings amount to at least 112% of your total 2001 tax liability.

Taxes are due in April, June, September, and January of each year. The total tax bill that you'll need to estimate and pay in quarterly chunks is figured by taking all the taxes you owe and subtracting all the credits you have. The taxes are filed with 1040-ES forms, available from the IRS and sometimes at your local library or post office.

For the tax year 2002, the due dates are:

  • First quarter: April 15, 2002
  • Second quarter: June 17, 2002
  • Third quarter: September 16, 2002
  • Fourth quarter: January 15, 2003

Keep in mind that if an income spike occurs 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 the time when you 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.

The details
If this is the first year that your income has spiked or otherwise increased substantially, you still might not have to pay estimated taxes and might be able to pay the entire balance due on April 15 without penalty by using the so-called "exception #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 2002 income and pay any balance due with the tax return on April 15 without penalty.

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. So if your tax liability was $12,000 last year, but this year you expect to sell some stock and have substantially higher taxes to pay, you'll probably have to pay estimated taxes. But you can use the safe harbor and just make sure that you pay at least $12,000 in estimated (or withheld) taxes.

Note that the above-100% safe harbor is not for every one. If you're a high-income taxpayer with AGI of more than $150,000 in the prior year, your safe harbor is different. The safe harbors that apply to you are:

  • For tax year 2001, if you pay 110% of your 2000 tax liability, you'll be safe.
  • For tax year 2002, if you pay 112% of your 2001 tax liability, you'll be safe.
  • For tax years 2003 and beyond, if you pay 110% of your 2002 tax liability, you'll be safe.

Let's consider a high-income scenario now. Imagine that in 2000, your total tax liability was $56,100. In 2001, you know that you'll be selling some major stock holdings and will realize some hefty capital gains. Your total tax liability for 2001 will be considerably higher than that for 2000. Just to be sure, you check to see how much tax will be withheld for you, and it's well under 90% of what you expect to owe. Thus, you definitely will have to pay estimated taxes. How much do you fork over, then? Well, according to the table above, for 2001, you can get away with simply paying 110% of what you paid in 2000, or $56,100. So you might not even need to bother tinkering with your W-2 withholding, if it will suffice.

The entire amount of $56,100 will have to be withheld and/or paid via estimated taxes. If you have no W-2 withholding, the entire $56,100 amount will have to be paid via estimated taxes equally over all of the installments. This amounts to $14,025 per quarter and gets you under the safe-harbor umbrella. If it is a combination of W-2 withholding and estimated tax payments, the estimated tax payments must still be made equally over the year, regardless of the amount. Remember that the W-2 withholding can still be "backloaded." As long as the total of the two equals or exceeds the $56,100 amount, things will be just fine.

Now let's move forward a year to 2002. You'll be obligated to fork over in estimated taxes 112% of your previous year's tax liability. But then, in 2003, that rate will fall back to 110% again. (That may look like an error of some sort, but that's the way it is.)

Declining income
When your income drops (such as after a year with extraordinarily large gains), you may have a bit of a problem. If your normal withholding will cover your total tax liability for the year, then you're in phat city -- and have no worries.

But what if your withholding still won't cover your total tax liability, and 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 running a little "mini" tax return each quarter, basing your estimated tax payments on the results of your computations. It's a pain, but it may have to be done if you want 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." That sounds good in theory, but think about it. If your 2001 total tax liability was $75,000, and you expect your 2002 total tax liability to only amount to $15,000, do you really want to overpay your taxes by $60,000 simply to avoid some computations? It's probably best to just struggle and complete the computations on a quarterly basis.

On the other hand, if you have a pretty good handle on what your total tax liability will be for 2002, 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 do it -- you're still making some overpayments that you really don't need to make -- 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 get hit with the penalty. So you'll have to keep an eye on your estimates all year 'round.

To learn more about estimated taxes, head over to IRS Publication 505, "Tax Withholding and Estimated Tax." High-income taxpayers especially need to fully understand the safe-harbor computations and percentages and the special rules that apply.  Additionally, there's a nifty website that can help you make decisions relative to your estimated taxes, what to pay, how and when to pay them, and how to avoid underpayment penalties. Check out www.edcosoft.com.

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.

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.