P is for Penalty on Estimated Tax.
If you receive payments or other funds without having any federal income taxes withheld, you should consider making estimated payments throughout the year to avoid any penalties. This applies not only to the self-employed or occasional freelancers but also to those taxpayers who may receive income from other sources not subject to withholding; these tend to be landlords, S corporation shareholders, partners in a partnership or taxpayers with significant investments.
If you are filing as an individual taxpayer, you generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your federal income tax return. Take a look at line 76 of your form 1040: if it is at least $1,000, you should likely be making estimated tax payments.
Similarly, if you owed federal income tax last year and expect to owe again this year, you may also have to pay estimated taxes for the current year. Some exceptions and special rules apply, so check out federal form 1040-ES (downloads as a pdf) for more information.
To make estimated payments, you’ll figure your estimated tax; you can use the worksheet on the federal form 1040-ES to figure your estimated tax. For estimated tax purposes, the year is divided into four payment periods, about once every quarter. Each period has a specific payment due date as determined by IRS (usually April 15, June 15, September 15 and January 15). Watch the dates carefully: if you don’t pay on time, you may be subject to a penalty.
If you don’t make enough in estimated payments for 2011, you may owe a penalty if the total of your withholding and timely estimated tax payments did not equal at least the smaller of:
- 90% of your 2011 tax, or
- 100% of your 2010 tax. This amount is considered the “safe harbor” amount. A good rule of thumb if your income doesn’t change from year to year is to pay at least as much as you owed in tax for the prior year. There is one quick exception: if your adjusted gross income (AGI) for 2010 was more than $150,000 ($75,000 if your 2011 filing status is married filing separately), you must pay at least 110% of your 2010 tax for the safe harbor amount.
If you are subject to a penalty for not making enough estimated tax payments throughout the year, you can figure the penalty by using federal form 2210 (downloads as a pdf). The penalty amount is entered on your return at line 77; add the penalty to your total tax due and enter that amount on line 76.
A good example of when a form 2210 comes in handy is when your income varied during the year and your penalty is reduced or eliminated when figured using the annualized income installment method. Taxpayers use this method when income is uneven throughout the year; for example, instead of receiving a regular paycheck every other week, the bulk of your income comes in summer due to seasonal employment. When this happens, your estimated tax payment is figured at the end of each period based on a reasonable estimate of your income, deductions, and other items from the beginning of the tax year through the end of the period. While this method can save you from unwanted penalties, it can also be tricky.
You will not file form 2210 with your return unless the instructions on the form indicate that you must. Typical situations that would require the filing of form 2210 would include a request for waiver of part or the entire penalty. There is an exception to this rule for weather-related issues. Last year, floods, hurricanes, tornadoes and fires created havoc across the country and interfered with making estimated payments. If you lived in a federally declared disaster area and were granted a break on making estimated payments, you do not have to do anything special and you do not need to file form 2210. The IRS will automatically identifies taxpayers located in a covered disaster area and will apply the appropriate penalty relief. If you still owe a penalty after the automatic waiver is applied, the IRS will send you a bill.
If the math is too much for you, you can use tax prep software to figure the amount due. You can also choose to leave line 77 blank and the IRS will figure your penalty and send you a bill unless you use the annualized income installment method (this is where that tax pro comes in handy). The IRS won’t charge interest on the penalty amount if you pay by the due date on the bill.
It’s important to try to file and pay your estimated payments by the applicable deadlines but if you miss one, don’t assume all is lost and just ignore it. Ignoring a missed payment won’t make it go away (anymore than ignoring a bill will make it go away). If you miss a payment, simply file and pay as soon as you can. Remember that penalties are imposed on each underpayment for the number of days it remains unpaid so it’s to your advantage to pay as soon as you can.
Of course, if you miss a payment, there’s no need to panic either. The penalty is worth, roughly, the unpaid interest on the estimated payment. It’s not huge but it’s not worth racking up.
One final note: penalties for estimated tax payments are not deductible, even if they are related to your business.
For more in the series, see:
Taxes from A to Z: A is for Alimony
Taxes from A to Z: B is for Barter
Taxes from A to Z: C is for Capital Losses
Taxes from A to Z: D is for Deductible Taxes
Taxes from A to Z: E is for Educator’s Expenses
Taxes from A to Z: F is for FSA
Taxes from A to Z: G is for Gift Expenses
Taxes from A to Z: H is for Home Improvements
Taxes from A to Z: I is for Injured Spouse
Taxes from A to Z: J is for Job Search Expenses
Taxes from A to Z: K is for Kiddie Tax
Taxes from A to Z: L is for Levy
Taxes from A to Z: M is for Making Work Pay Credit
Taxes from A to Z: N is for Noncitizen Spouses
Taxes from A to Z: O is for Offer in Compromise