Estimated tax withholding refers to a system where taxpayers pay their income tax throughout the year on income not subject to standard paycheck withholding. Although the process can be relatively complex when it comes to tax obligations, it is a requirement, particularly for those who are self-employed, to cover their tax obligations to avoid underpayment penalties.
How Does Estimated Tax Withholding Work?
Estimated tax withholding payments are made every quarter, and payments are sent to the IRS (and in some cases the applicable state) four times a year, with deadlines arriving on April 15, June 15, September 15, and January 15 each tax year.
Workers are responsible for estimating their adjusted gross income, taxable income, and tax credits for the year and can use Form 1040-ES to calculate their payments. Generally speaking, payments must total at least 90% of the current year’s tax liability or 100% of the previous year’s tax liability to avoid incurring underpayment penalties.
Estimated tax withholding payments can be paid online via the IRS website, or by using the IRS2Go mobile app. Alternatively, it’s possible to pay by mail.
Who Is Liable for Estimated Tax Withholding?
Estimated tax payments are a requirement for individuals who receive an income from which taxes aren’t typically withheld. With this in mind, some instances that are liable for estimated tax withholding include:
- Self-employed workers or freelancers who receive earnings from contract-based work
- Investment income, including interest, dividends, and capital gains
- Rental property income
- Certain prizes or legal settlements
- Pension or annuity payments (however, voluntary withholding is usually an option)
Most employees will have their tax obligations covered by their employer; if they have multiple sources of revenue for the tax year, they may be liable to pay estimated tax withholding.
What are the Penalties for Underpayments?
Tax withholding penalties, also known as underpayment penalties, happen when a taxpayer doesn’t pay the right amount of tax throughout the year through their estimated tax payments.
Penalties for underpayments are calculated on the amount that’s still outstanding for each quarter, plus the current interest rate.
As a rule of thumb, paying at least 90% of the tax owed for the current year, or 100% of the tax paid for the year prior, is generally considered sufficient to avoid penalties. This figure climbs to 110% for high-income taxpayers. This is popularly known as the ‘safe harbor’ rule.
Some exemptions apply when it comes to estimated tax withholding underpayments, and the penalty could be waived if the individual meets a certain criteria, such as if they are retired or have become disabled during the tax year.
How to Avoid Underpayments
Underpayments can be successfully avoided by regularly making quarterly estimated tax payments.
To help support accuracy in tax payments, there are plenty of different software solutions that can be used, which are capable of adapting to the different circumstances of taxpayers. Financial advisors can also help ensure that no underpayments are made when making estimated tax withholding payments.
FAQs
While estimated tax withholding refers to payments made directly by individuals to the IRS to cover income not subject to standard withholding, wage withholding is managed by an employer on behalf of their workers.
In the case of wage withholding, tax deductions are handled on behalf of the employer and sent to the government.
If you’ve underpaid your estimated tax withholding, the IRS will charge an underpayment penalty, which will stand as a separate charge to your regular tax liability.
However, if you’ve failed to make a payment or have paid too little, you can file a preliminary return and pay the outstanding amount you estimate is due to lower the impact of the penalty. It’s also possible to make a late estimated payment after the quarterly deadline.