Uncle Sam wants your tax money ... now. So, if you aren't sending the IRS enough money in your quarterly tax installments, you may need to pay an extra interest-rate penalty.
You can hold onto your cash longer if you qualify for any one of three IRS-approved "safe-harbor" methods of calculating your estimated tax payments.
Advice: Switch to the safe-harbor method that enables you to pay the least amount of estimated tax during the year. And don't feel the need to wait until year-end to switch. Nothing in the tax law says you must use the safe-harbor method that's worked best for you in the past, or even the method you used earlier this year.
Choose one of 3 methods to calculate estimated tax
You're required to pay your annual income tax in quarterly installments or through payroll tax withholding (or a combination of both).
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 a holiday).
But you can sidestep an estimated tax penalty by using any one of these three safe-harbor methods to calculate your estimated tax payments:
Option 1. You pay at least 100 percent of the prior year's tax liability, spread out over four payments (110 percent if your adjusted gross income (AGI) for 2004 exceeded $150,000).
Option 2. You pay at least 90 percent of the current year's tax liability, spread out over four payments.
Option 3. You pay at least 90 percent of the current year's "annualized income," spread out over four payments. That method works best for certain people, such as independent contractors, who earn income in bursts throughout the year.
For most working people, Option 1 is the easiest: Simply adjust your payments to equal 100 percent or 110 percent of the prior year's tax liability.
But the easiest way isn't always the best way. You may be able to pay Uncle Sam less upfront—and keep more dollars in your own pocket for longer—by switching safe-harbor methods midyear.
Example: A switch in time saves tax
Say you're self-employed with a $20,000 tax liability in 2004. To keep things simple, say you've just paid (by the April 15 deadline) 25 percent of last year's tax liability—or $5,000—as your first quarter estimated tax payment. That's right
in line with your income for the first quarter.
But suppose your business declines substantially in the second quarter, resulting in a $4,000 tax liability. If you pay another $5,000 on June 15, you'd be overpaying Uncle Sam for the quarter.
So, instead of using the 100 percent safe-harbor method, you switch over to Option 2, the method based on 90 percent of your current tax liability. As a result, your second-quarter tax payment comes to $3,600. That's $1,400 less than the first quarter.
You can also choose to use Option 3, the annualized method, which involves a few extra calculations.
Bottom line: No matter which method you use, each quarterly installment can stand on its own. But the payment you make for that particular quarter, plus the amounts paid in previous quarters, must equal the amount you would have paid if you were using the new method all along.
Figuring estimated tax
The IRS provides work sheets for calculating estimated tax liability in Publication 505, Tax Withholding and Estimated Tax. Access the work sheets at www.irs.gov/publications/p505/ch02.html. (They're an absolute must if you plan on using Option 3, the annualized method.)
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