The Internal Revenue Service requires certain taxpayers to make estimated quarterly payments during the year based on how much untaxed income they expect to earn. Calculating the amount due is an inexact science and the burden usually falls to self-employed individuals. If you don't work for someone who withholds taxes from your pay and sends the money to the IRS on your behalf, you're responsible for making these payments yourself. If you underestimate what you owe -- or worse, if don't make any payments -- the IRS imposes a penalty.
Estimated Quarterly Taxes
Estimated taxes are due four times a year: April 15, June 15, Sept. 15 and Jan.15. This last payment represents the tax due on income earned in the final quarter of the previous year. The IRS wants its money quarterly if you're self-employed, just as it would receive it on an incremental basis if an employer had been withholding taxes from your pay. You must file Form 1040-ES, calculating what taxes you'll probably owe based on your previous year's tax return. If this is the first time you're paying estimated taxes, you'll have to guess at what you think you'll earn. If it turns out that your estimate is off, you can file a new, corrected 1040-ES each quarter. If you don't pay by the due date for each quarter, your payment is considered late; you can't just pay up at the end of the year when you file your tax return. But if you expect that you'll owe less than $1,000 in taxes on your untaxed income, you're off the hook -- unless you're wrong and your tax owed turns out to be greater than this.
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The Underpayment Penalty
If you underestimate what you owe or don't make estimated payments at all, the IRS adds a 0.5 percent penalty, half of 1 percent, to your outstanding balance. This may not be as negligible as it sounds because it's levied each month until you catch up and pay all taxes due at that time. If you don't make any quarterly payments, the 0.5 percent accrues on your total tax owed each month. Otherwise, it's a percentage of the difference between what you paid in and how much you ultimately ended up owing when you filed your tax return.
Exceptions to the Rule
If you're financially unable to pay your taxes in one lump sum and you enter into an installment agreement with the IRS, the penalty drops to 0.25 percent. No penalty is imposed if your estimated payments fall short but are at least equal to what you owed the year before. There's no penalty if your estimated payments are off by 10 percent or less, provided you made all your quarterly payments on time. If you had no tax liability the previous year, you won't be penalized, and if the total tax you owe is less than $1,000, you may escape the penalty in this case as well.
Notice and Demand for Payment
If you don't pay enough during the year and you end up owing a penalty, the IRS will send you a notice and demand for payment, telling you the amount of the penalty. Unfortunately, by the time this happens, the penalty jumps from 0.5 to 1 percent the day after the notice is issued to you, so you don't want to wait until you receive notice before you pay up.