In certain situations it is necessary for individuals to make estimated quarterly tax payments using the Form 1040-ES payment voucher. Estimated tax payments are necessary when income is derived from sources that are not subject to withholding such as interest, dividends, gains from sales of assets, rental income, royalties, schedule E pass-through income, and self-employment income. Estimated tax payments may be used to pay income tax as well as self-employment tax. You may also need to make quarterly estimated tax payments if the amount of income tax withheld from your wages is not sufficient to cover 90 percent of your tax liability and you expect to owe more than $1,000 with your tax return.
For a calendar year 2014 taxpayer the estimated quarterly tax payment system divides the year into these four installment periods:
Period ending Estimated tax payment due
March 31, 2014 April 15, 2014
May 31, 2014 June 16, 2014
August 31, 2014 September 15, 2014
December 31, 2014 January 15, 2015
When your 2013 (prior year) tax return was prepared, a calculation should have been made to determine if 2014 quarterly estimated tax payments were needed and in what amounts. If you expected your withheld taxes and refundable credits to leave you more than $1,000 shy of your actual 2014 tax liability, you should have calculated quarterly estimated tax payments.
The law does not actually obligate you to pay estimated taxes, however, it imposes a penalty for failure to pay enough tax through withholding or estimated taxes. To avoid the penalty an individual generally would need to adjust their withholding or make four installment payments based upon his or her estimated total tax for the year. The installments would each be 25 percent of the lesser of:
- 90 percent of the tax shown on the individual’s tax return for the current year, or
- 100 percent of the tax shown on the prior year’s return (110 percent in the case of an individual with adjusted gross income (AGI) in excess of $150,000 ($75,000 for a married individual filing separately)
When the prior year tax return was prepared, consideration should have been given to anticipated income for the next year. Generally, we would take the approach of calculating the 100 or 110 percent safe harbor estimated tax payments unless the client has indicated an expected decline in income for the next year or we are aware of significant one time income items that skew the prior year’s income.
Many of our clients have AGI in excess of $150,000 so the calculation of the following year estimated tax payment amounts is as follows:
- Prior year tax times 110%
- Subtract the prior year withholding (assuming it will reoccur in the next year)
- Divide the result by 4 and round to the nearest $10, $100, or $1000 depending on the amount
There are, however, a number of situations that present themselves that lead us to calculate next year’s estimated tax payment amounts at the 90 percent safe harbor level. Situations such as capital gains in one year that are not expected to reoccur, self-employment or pass-through income that is declining, a deduction item that was smaller than normal in one year and will increase in the next year.
In these cases, we work closely with the client to estimate significant items of income and various deductions for the next tax year. Based on the anticipated numbers for the next year we calculate the quarterly estimated tax payments at 100 percent of the estimated tax to give a cushion with respect to the requirement of 90 percent.
Sometimes, however, individuals income and deduction situations are subject to annual fluctuation and not very predictable. Occasionally, we make the 90 percent calculation for the next tax year and then during that year a tax event happens that requires the payment of additional tax in the form of quarterly estimated payments. Once you elect to go with the 90 percent threshold rather than the 100/110 percent threshold, you cannot go back to the 100/110 percent threshold without suffering a penalty for the quarters that have already occurred. Furthermore, if you are using the 90 percent threshold for satisfying the estimated tax payments and a taxable event occurs, you will most likely need to pay the tax associated with that event by the due date of the next quarterly payment.
When significant taxable events occur during the year that were not anticipated and you have been using the 90 percent threshold, you may actually find yourself paying greater amounts of estimated taxes than you would have had you originally used the 100/110 percent threshold.
As the third quarterly estimated tax payment due date for 2014 is upon us, many taxpayers begin to see a clearer picture of their actual results for the tax year and they begin to ask about modifying their fourth and maybe even their third quarterly estimated tax payment. If you have experienced lower amounts of income or have larger deductions for the current year compared to the prior year, and you utilize estimated tax payments to satisfy your payment of taxes, you may be well advised to contact your CPA to review your tax situation.
Another point about estimated tax payments that is worth reviewing is the nature of the payment and who knows about it or expects you to make it. As I wrote earlier, the law does not directly impose an obligation to pay estimated taxes. The fact that your CPA provided you with a set of quarterly payment vouchers is simply a matter between you and your CPA. The IRS does not have a copy of those vouchers or the payment schedule your CPA provided you. The IRS does not have an amount in their system that they are expecting to receive from you. If you do not pay your fourth quarter payment because your income declined or your deductions increased, the IRS is not going to send you a bill and expect a payment from you. Once per year when your tax return is completed your payments of tax compared to your actual tax will matter and will result in tax due with the return (and possibly penalty and interest if the circumstances warrant) or an overpayment (which may be refunded or credited forward to the next tax year). The other misunderstood aspect of estimated tax payments is that your CPA does not know that you paid them unless you provide such information the same as you must provide documentation about sources of income and deductions. It is true that the CPA may have prepared the estimated tax vouchers, but he or she does not know whether you paid them or not.
In summary, it is important to know whether you are paying estimated taxes based on the prior year (100/110 percent) threshold or the current year (90 percent) threshold. It is important to evaluate your tax situation in the third and fourth quarters to determine if you can possibly modify either of the quarterly estimated payment amounts. Now is a good time to contact your CPA if your income or deduction amounts have changed since last year.