Don’t be caught off-guard by the next installment due date for estimated taxes. Fortunately, you can avoid tax penalties if you paid the amount required under one of three safe-harbor methods.
Strategy: Use the safe harbor method that suits you best. You might even switch methods midway through the year. There’s nothing in the tax law requiring you to stick with the same method through thick and thin.
Here’s the whole story: You’re generally required to pay annual income tax in quarterly installments or through payroll tax withholding (or a combination). The quarterly due dates for the tax payments are April 15, June 15, Sept. 15 and Jan. 15 of the following year (or the following business day if the due date falls on a weekend or holiday). Failure to pay the required tax can result in the penalty.
However, you can sidestep any problems by using any one of these three safe harbors.
1. You pay at least 90% of the current year’s tax liability. This requires you to make a calculated “guesstimate” of your current tax situation.
2. You pay at least 100% of the prior year’s tax liability (110% if your adjusted gross income for the prior year exceeded $150,000). This is often the easiest method to use because you know the exact amount of your previous tax liability.
3. You pay at least 90% of the current year’s “annualized income.” The annualization method often works well for certain individuals, such as independent contractors, who receive most of their income on a seasonal basis.
Of course, the easiest way isn’t always the best way. For instance, you might be able to pay the IRS less up front, and keep more tax dollars in your own pocket, by switching safe harbor methods before the end of the year (see box below).
Tip: The IRS provides work sheets to help you calculate estimated tax liability in Pub. 505, Tax Withholding and Estimated Tax. Find them at www.irs.gov/pub/irs-pdf/p505.pdf.
Online resource: IRS on YouTube. The IRS describes situations in which you should consider paying estimated taxes. Go to www.youtube.com/watch?v=DM5XxKCATv0.