Estimated Tax Payments: How to Determine What You Pay and When

If you're an employee, your employer withholds taxes from every paycheck and sends the money to the IRS and possibly to your state government as well. This way you pay your income taxes as you go. And, if you're like most wage earners, you get a nice refund at tax time.

But if you are self employed, or if you have income other than your salary, you may need to pay estimated taxes each quarter to square your tax bill with Uncle Sam. You may owe estimated taxes if you receive income that isn't subject to withholding, such as:

• Interest income
• Dividends
• Gains from sales of stock or other assets
• Earnings from a business
• Alimony

Do I Need to Pay Estimated Taxes?

That depends on your situation. The rule is that you must pay your taxes as you go. If, at filing time, you have not paid enough income taxes through withholding or quarterly estimated payments, you may have to pay a penalty for underpayment.

To determine whether you need to make quarterly estimates, answer these questions:

• Do you expect to owe less than $1,000 in taxes for 2007 after subtracting your federal income tax withholding from the total amount of tax you expect to owe? If so, you're safe -- you don't need to make estimated tax payments.
• Do you expect your federal income tax withholding (plus any estimated taxes paid on time) to amount to at least 90% of the tax that you will owe on for 2007? If so, then you're in the clear and you don't need to make estimated tax payments.
• Do you expect that your income tax withholding will be at least 100 percent of the tax on your 2006 return? Or, if your adjusted gross income (Form 1040, line 37) on your 2006 tax return was over $150,000 ($75,000 if you're married and file separately in 2007), do you expect that your income tax withholding will be at least 110% of the tax you owed on for 2006? If so, then you're not required to make estimated tax payments.

If you answered no to all of these questions, you must make estimated tax payments with Form 1040-ES. To avoid a penalty, your total tax payments (estimated taxes plus withholding) during 2007 must satisfy one of the requirements we just covered.

Which Option Should I Choose?

That depends on your situation.

The safest option to avoid an underpayment penalty for 2007 is to aim for "100 percent of your 2006 taxes." If your 2006 adjusted gross income was more than $150,000 (or $75,000 for those who are married and filing separate returns in 2006), you will have to pay in 110% of your 2006 taxes. If you satisfy either test, you won't have to pay an estimated tax penalty, no matter how much tax you owe with your 2007 tax return.

If you expect your income in 2007 to be less than in 2006 and you don't want to pay more taxes than you think you will owe at year end, you can choose to pay 90 percent of your estimated 2007 tax bill. If the total of your estimated payments and withholding add up to less than 90 percent of what you owe, you may face an underpayment penalty. So you may want to avoid cutting your payments too close to the 90% mark to give yourself a little safety net.

If you expect your 2007 income to be more than 2006's income and you don't want to end up owing any taxes when you file your 2007 return, try to make enough estimated tax payments to pay 100 percent of your 2007 income tax liability.

How Should I Figure What I Owe?

You need to come up with a good estimate of the income and deductions you will report on your federal tax return next year.

You can use a tax software program, such as TurboTax, or get a copy of the worksheet accompanying Form 1040-ES and work your way through it. Either way, you'll need some items so you can plan what your estimated tax payments should be:

• Your 2006 return. Use your 2006 federal tax return as a check to make sure you include all the income and deductions you expect to take on your 2007 tax return. You should also look at the total tax you paid if you are going to base your estimate tax payments on 100 or 110 percent of 2006's taxes.
• Your record of any estimated tax payments you've already made for 2007. You need to take those payments into account when you determine how much tax you still owe, so have your check register handy so you can look up the amounts and dates you paid.

Tip

One way to get a jump on paying your 2007 taxes is to apply your 2006 tax refund to your 2007 taxes instead of getting a refund. If you won't have federal income tax withheld from wages or if you have other income and your withholding will not be enough to cover your tax bill, you probably need to make quarterly estimated tax payments. Having all or part of your overpayment applied to your estimated taxes is a relatively painless way to take care of some of what you owe for 2007.

What If I Do Not Pay?

You could end up owing the IRS an underpayment of estimated tax penalty in addition to the taxes that you owe.

Result: you have to write a larger check to the IRS when you file your return.

Should I Pay in Equal Amounts?

Usually, you pay your estimated tax payments in four equal installments. But you might end up with unequal payments in some circumstances:

• If you have your 2006 overpayment credited to your 2007 estimated tax payments
• If you don't figure your estimated payments until after April when the first one is due
• Or if you unexpectedly make a lot of money one quarter

Example

You calculate that you need to pay $10,000 in estimated taxes throughout the year, and you don't make your first payment until June 15 (when the second estimate is due), so your first payment will be $5,000. Your September payment and your January 2008 payment will be $2,500 each. However, you may still owe an underpayment penalty for the first quarter.

If You Are a Farmer or Fisherman

You have special criteria to meet, but you may end up paying less in estimated taxes. You're considered a qualified farmer or fisherman if you earn more than two thirds of your gross income from farming or commercial fishing. If you're not sure you qualify, or how this all works, get IRS Publication 595: Tax Highlights for Commercial Fisherman, or IRS Publication 225: Farmer's Tax Guide. These publications tell you how to figure your gross taxable income and what fishing and farming income you can include as qualified income.