For those who work as independent contractors or make over a certain amount of money independently, you are required by federal law to pay estimated taxes. While the IRS can’t perform withholding due to the nature of the way your payments are received for work performed, the agency can require you to pay a quarterly estimate of your income taxes as a substitute. This allows the agency to receive your taxes in a timely manner similar to regular employees who see deductions from their paychecks.
Because estimated taxes are in fact an estimate, you will declare what you paid to the IRS after the tax year is over and you file your taxes. As you calculate the taxes you owe, your estimated tax payment will offset that liability, reducing the amount still owed if any. If in fact your estimated payments were too much, then they will contribute to a tax refund paid back after you file. The process works similar to withholding that regular employees pay into and get back at tax time.
Types of income that can trigger estimated taxes vary. For instances, one-time amounts of money received such as lottery prizes, gifts, or awards can all trigger tax liabilities since the IRS generally considers this new income to you. Additionally, if your investments result in a significant payout or a distribution from a tax-sheltered account, then you may have taxes due as well.
Estimated tax payments are required if the following criteria is met in a given tax year. First, you make enough money in the year that you will owe at least $1,000 in taxes after adjusting for tax credits and adjustments. Second, any withholding that has been performed on your pay as well as tax credit comes out to being 90 percent or less than your taxes due or less than 100 percent of what you paid for the prior year. Note that there are some exceptions to the rules for those who make a living from farming or fishing.
Where your income comes from a business such as a sole proprietorship, a partnership, or a corporation then you still have to pay estimated taxes if you figure your will end up owing at least $1,000 in taxes. However, if you also work as an employee for someone and pay withholding, the estimated payments rule may not apply. Much depends on how much you paid in withholding versus what you owe.
Calculating what you may owe in estimated taxes takes a bit of math. The preliminary step involves determining what you believe your gross income will end up being for the year. Then you need to apply your expected adjustment to figure out your taxable income, including any tax credits or deductions you will be eligible for. At this point you should be fairly close to the income figure you then need to use against the IRS tax tables. From there you can figure your tax liability and, divided by 4, the quarterly amount due. Quarterly payments are then made every April 15, June 15, Sept. 15 and Jan. 15 for the prior time period.
The payment for the quarter needs to be sent in with IRS Form 1040ES – Estimate Tax for Individuals. This voucher then tells the IRS what the payment is for and to whose tax record to apply it to. When you file your taxes at the end of the year and claim estimated taxes paid, the IRS will cross reference your tax filing with the estimated payments received per your vouchers.
More details can be found in IRS Publication 505 -Tax Withholding and Estimated Tax. The manual can either be downloaded over the Internet from the IRS’ website at www.IRS.gov or you can request a hardcopy be mailed by calling the agency at 800-TAX-FORM (800-829-3676).
Sources:
IRS Form 1040ES, Estimated Tax for Individuals
IRS Publication 505, Tax Withholding and Estimated Tax