If you are self-employed, or if you work as an independent contractor, you will need to pay taxes on your estimated annual income at four-month intervals rather than in a single chunk on April 15. These estimated tax payments cover income taxes and self-employment taxes related to Social Security and Medicare. Self-employed individuals and independent contractors thus need to calculate their estimated taxes and subtract this amount from their earnings on a regular basis. Otherwise, they might incur tax debt in addition to penalties for violating these rules.
You will need to pay estimated taxes if you own your business and expect to owe at least $1,000 in taxes. There is an exception for some sole proprietors who were not required to pay taxes in the previous year. This exception applies regardless of how much they earn in the current year. The exception does not apply if you were not a U.S. citizen or green card holder for the tax year, or if your previous tax return did not cover all 12 months of the previous year.
Making Payments for Estimated Taxes
You can calculate the amount of your estimated taxes from the tax return for the previous year. Your estimated taxes will consist of either the same amount of tax that you paid in the previous year or 90 percent of your total tax due for the current year, whichever amount is smaller. Different rules may apply to people with very high incomes. You will file estimated taxes by using Form 1040-ES, together with payment vouchers.
For income received between January 1 and March 31, estimated tax is due on April 15. For income received between April 1 and May 31, estimated tax is due on June 15. For income received between June 1 and August 31, estimated tax is due on September 15. For income received between September 1 and December 31, estimated tax is due on January 15 of the following year.
You do not need to make estimated tax payments until you start earning income. In most cases, the first of the four estimated tax payments falls on April 15, but people who do not receive income by March 31 can skip that payment. They would need to make three payments, starting on June 15. Similarly, someone who does not receive income by May 31 can skip the June 15 payment.
Penalties for Failing to Pay Estimated Taxes
Paying an inadequate amount of estimated taxes can result in a modest penalty. This will consist of a percentage for each day on which the appropriate amount was not paid. The percentage varies from year to year, but the IRS often sets it in a range around 6 or 8 percent. Since the penalty is not severe, some people would prefer to pay it rather than paying estimated taxes throughout the year. This will allow them to keep the money in their business until the end of the year. They may view the penalty as being similar to interest paid on a loan, which would be charged at a comparable rate.
However, a self-employed person or independent contractor will need to pay all of the taxes that they actually owe to the IRS by April 15 of the following year. Penalties and interest for failing to pay by that date are much more severe.