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How to Calculate Estimated Taxes

By Wendy Connick - Aug 5, 2017 at 6:35AM

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Business owners, independent contractors, and retirees usually need to make estimated tax payments -- but figuring out how much to pay can be a challenge if you don't know about the safe harbor hack.

Most people who are employees don't have to worry about estimated taxes because they have taxes withheld from their paychecks. If you're not an employee, however, then there's no one withholding taxes from your paycheck for you. And if you'll owe more than $1,000 in federal taxes at the end of the year -- which, if you're not subject to withholding, is pretty likely -- the IRS requires you to make estimated tax payments four times a year rather than waiting until April 15 to pay it all.

What are estimated taxes?

When you work for an employer who withholds taxes for you, the IRS knows that it's going to get most if not all of its tax money during the course of the year. But if you don't have withholding on your income, the agency fears that you might spend all your money and not have enough to pay them come tax time. So the IRS insists that instead of waiting until you file your tax return to pay all your taxes, you must make quarterly payments in advance.

Estimated payments are typically due on April 15, June 15, and September 15 of the tax year, and the final payment is made on January 15 of the following year. If any of these days falls on a holiday or weekend, you have until the following workday to make your payment.

Calculating your taxes

Image source: Getty Images.

Estimating your tax payments

The trickiest part of making estimated tax payments is figuring out how much to pay. After all, your first payment is due just 4 1/2 months into the year. How do you know at that point how much you'll make for the whole year and therefore how much you'll owe in taxes? This is particularly challenging the first year you make estimated payments, since in subsequent years, you can at least make a guess based on the previous year.

If you mess up and under-pay your estimated taxes, not only will you have a huge tax bill at the end of the year, but the IRS will charge you an underpayment penalty. However, there's a hack you can use to avoid the penalty even if you have no idea how much income you'll make for the year.

Estimated tax safe harbor

The IRS says that for most taxpayers, if your estimated tax payments equal at least 90% of the total that you ended up owing for the year, or at least 100% of the tax you paid on the previous year, you won't get hit with an underpayment penalty. So even if you've got absolutely no idea how much you'll owe for the current year, you can still use the previous year's numbers to calculate your estimated payments. Even if those payments end up being way off the mark, you won't owe a penalty.

How to safely calculate your tax payments

To use the safe harbor, you'll need your previous year's tax return. You're looking for the line on the 1040 that lists the total tax you paid for the year -- in 2016, it was line 12 on the 1040EZ, line 39 on the 1040A, and line 63 on the 1040. Take that number and divide it by four, and you've got the amount you should pay for each estimated tax payment.

For example, if you discover from your previous year's tax return that you owed $30,000 in taxes last year, then that means each of your estimated tax payments for the current year should be at least $7,500. Even if it turns out that you owe $60,000 in taxes this year instead of $30,000, because you paid 100% of the previous year's taxes in estimated payments, the IRS won't charge you an underpayment penalty.

Correcting in midstream

However, if it turns out that you make way more income this year than the previous one, you'll end up owing a huge amount in taxes at the end of the year. If you realize mid-year that your estimated tax payments are much lower than the actual taxes you're accruing, you need to either increase your estimated tax payments or save a lot of money for your final April 15 tax bill.

On the other hand, if your income turns out to be significantly lower than the previous year's, then your estimated payments using the safe harbor will be way higher than they need to be. Any overpayments that you make for the year will be returned to you in the form of a tax refund when you file your return. However, you may not want to give the IRS a bunch of your money to hold onto for months and months, so if it becomes clear that your tax bill for the year will be much lower than the previous year's, you have the option of making your remaining estimated payments smaller than planned. And if it turns out that the first three estimated payments took care of your entire tax bill for the year, you can just skip the final payment on January 15.

An exception to the safe harbor rule

If your adjusted gross income for the previous year was above a certain amount, the safe harbor estimated payment rule changes a bit. In that case, you're required to pay 110% of the previous year's taxes, not 100%. For 2017, the threshold is an AGI exceeding $150,000, or $75,000 if you have a status of married filing separately for the year.

As an example, say your AGI for 2016 was $180,000, and you paid taxes of about $43,440 for the year, then for 2017 each of your estimated tax payments would have to be at least $11,950 to be sure of avoiding the underpayment penalty. It's a small price to pay for enjoying a high income, but one you should be aware of.

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