Estimated Tax Payment Basics.
The amount that must be paid to the IRS can be determined using one of three methods: prior-year method, current-year method, or annualization method. An underpayment penalty won't be assessed if estimated payments and withholdings equal the amount determined under one of the methods.
* Prior-year method. Under this method, payments for 1999 must equal the 1998 total tax liability, provided the taxpayer's 1998 adjusted gross income (AGI) was $150,000 or less. For individuals with AGI over $150,000, estimated payments and withholdings must equal 105% of the 1998 tax liability. (This amount will increase over the next several years, to 106% for 2000 and 2001, 112% for 2002, and 110% for 2003.)
* Current-year method. Payments under this method must equal 90% of the 1999 tax liability.
* Annualization method. Under this method, 90% of the 1999 tax liability is based on annualization of actual year-to-date income for each quarter of 1999. This method is best used when an individual taxpayer's earnings fluctuate during the year. (For example, when there is an unexpected capital gain, or your income fluctuates with the yearly business cycle.)
Choosing a method
If estimated taxes are overpaid, the taxpayer has made an interest-free loan to the government. The goal in figuring estimated taxes is to pay the minimum amount necessary to avoid underpayment penalties. Each method has its advantages and disadvantages. For most individuals, the easiest way to calculate estimated tax payments is by using the prior-year method. This may not be possible for someone in a partnership or S corporation who may not have all of the prior-year information in time for the first estimated tax payment. The current-year method is also easy to use but requires the taxpayer to be fairly accurate in figuring his or her tax liability, which may not be possible for the first three-quarters of the year. This may pose a problem for someone whose salary is partly or wholly comprised of commissions or year-end bonuses.
The penalty for underpaying estimated taxes is a nondeductible interest charge on the underpayment amount. It is computed using the Federal short-term interest rate plus three percentage points. The penalty is computed for each quarterly installment; therefore, a penalty could be assessed even though a taxpayer made up the underpayment in a later quarter. The penalty interest rate is determined during the first month of each calendar quarter and becomes effective during the following quarter. The penalty is assessed from the due date of the installment payment until either the date the tax is paid, or the regular due date for filing the tax return, whichever is earlier.
Although withheld income tax payments are considered as being paid equally throughout the year, this rule does not apply to quarterly estimated tax payments. But if a taxpayer finds that previous estimated payments were not sufficient, he or she could avoid an underpayment penalty by adjusting withholdings for the remainder of the year. The taxpayer would have to file an amended Form W-4 with his or her employer.
Calculating payments and due dates
When calculating the estimated tax payments, taxpayers must include all sources of earned income, including income from passthrough entities such as partnerships, S corporations, and trusts. In addition, employment taxes for household employees and self-employment taxes must be included in your withholdings or estimated tax payments. Estimated payments are due April 15, June 15, September 15, and January 15.