Estimated Tax Explanation

When a taxpayer’s income isn’t subject to withholding taxes, they must make estimated tax payments to the Internal Revenue Service (IRS) each quarter.

If taxpayers earn income through wages, rent, interest, or dividends, and they don’t have an employer to withhold taxes from their paychecks, then it’s their duty to pay taxes on income.

In this article, you will learn more about estimated tax, how to calculate it, and when it’s your responsibility to report your returns to the IRS.

What is Estimated Tax

Taxpayers must pay federal and state taxes in the US according to the pay-as-you-go system. Employed individuals pay when their employers withhold taxes from their paychecks according to the W-4 information form they are required to complete. Self-employed taxpayers are supposed to pay estimated tax directly to the IRS rather than wait for the end of a year.

The examples of self-employed individuals who must estimate the amount of their taxable income are:

  • independent contractors;
  • landlords with rental gains;
  • investors receiving revenue from dividends and collect capital gains;
  • writers getting royalties on their works;
  • bondholders who generate interest income.

The list is extended to people receiving such potentially taxable income as unemployment compensation, Social Security or retirement benefits, and even alimony.

As mentioned, estimated taxes should be paid every quarter:

  • First period — first three months from 1st January to 31st March.
  • Second period — two months from 1st April to 31st May.
  • Third period — three months from 1st June to 31st August
  • Fourth period — the last four months of the year.

Taxpayers have to pay the IRS by 15th April, 15th June, 15th September, respectively, for the first three periods. The last period is due on 15th January of the next year. For example, you must meet the deadline to report the last four months of the year 2021 on 15th January 2022.

If a taxpayer’s estimated taxes do not equal 90% of their actual liability, they would have to pay the penalty. In case a taxpayer overpays, they get a refund. If the taxpayer’s net earnings are lower than $400, they don’t have to pay self-employment taxes. However, they are still required to file a tax return even if they gained less than $400.

Estimated Tax Explanation

Estimated Tax for Business Owners

If you own a business registered under these business structures, you must make estimated quarterly payments:

  • sole-proprietorship;
  • partnership;
  • S corporation shareholder.

It’s worth mentioning that you have to pay every quarter if you owe $1,000 or more. If it’s the first time you are filing the form, consider asking for the help of a certified public accountant. When filing an information form for the next year, you will have a clearer understanding of estimated payments based on the first year.

Estimated Tax Formula

The formula to calculate the estimated tax is as follows:

(Total estimated positive gains for the year – legal deductions) x federal rate = estimated tax.

According to the formula, you need to figure out your tax rate. Check the federal rate for the current period to find your bracket. Corporations should use Form 1120-W to calculate estimated tax, while individual taxpayers use Form 1040(ES).

Self-employed taxpayers have to include any gains they earn and deduct all allowable deductions. They must make correct calculations to avoid penalties. It’s a worse situation if you underpay than overpay since, as mentioned, you will get a refund.

Example of Estimated Tax Calculations

Now that you know the formula to calculate estimated tax let’s check a detailed example of calculations. Suppose we have a taxpayer, Mark, who provides car repair services and wants to calculate his estimated tax.

Calculate Taxable Income

Before filing taxes, Mark must estimate taxable income for the year. The first step is to figure out his estimated income to use in further calculations. Mark believes he will gain $100,000.

Then Mark subtracts all claimable above-the-line deductions, so the calculation is as follows:

$100,000 (income) – $15,000 (deductions) = $85,000

$85,000 is Mark’s “adjusted gross income.” Now it’s time to subtract the standard deduction for single taxpayers since Mark is single. In 2022, it’s $12,950. Mark may also subtract 50% of his self-employment tax.

Mark has to pay self-employment tax since he earns more than$400. Mark has to multiply his estimated total income of $100,000 by 92.35% to calculate self-employment tax. Then Mark must use this number ($92,350) to multiply by 15.3% – the self-employment rate. As a result, Mark has to pay $14,130.

Mark can deduct half of $14,130 which is $7,065. So, the taxable income is:

$85,000 – $12,950 – $7,065 = $64,985

Calculating Income Tax

To calculate income tax, Mark has to check the federal income rate bracket for the 2021-2022 period. Mark needs his taxable income and adjusts it by the federal rate. According to Mark’s bracket, he must pay $14,297.

Add Everything and Divide by Four

Now Mark must add his self-employment tax and income tax:

$14,130 + $14,297 = $28,427

Now Mark divides this number by four:

$28,427 / 4 = $7,106.75

So, each period Mark must submit a payment of $7,106.75.

The IRS has Form 1040-ES for individuals and 1120-W for corporations with worksheets. Check out calculations in the worksheet to calculate your estimated payments. You may also use free calculators online.

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