Don't Mess With Taxes

Yesterday's post on the impending estimated tax deadline prompted some readers to ask a follow-up question: Exactly how do you figure out what to pay the IRS via 1040-ES payment vouchers?

Regardless of how straightforward or convoluted your earnings situation is, the process is essentially the same.

First, you come up with a good estimate, which for many of us is a good guess, of what you expect your annual total income to be.

Next, make a down-and-dirty calculation of the taxes owed on that expected income. 

Then you figure what you'll be paying via withholding. Your withholding amounts can come from a FICA-withholding job you might have in addition to your untaxed earnings. If you're married and y'all file a joint return, your spouse's wage withholdings count, too.

Finally, you subtract your expected withholding amount from your expected taxes owed and the difference must be made up via estimated payments.

Unequal income, equal payments: The IRS prefers you do this in four equal installments. But life, and income, doesn't happen so neatly most of the time,

Figuring your estimated taxes gets tricky when you have untaxed income coming in unequally throughout the year. As a freelancer, I'm never quite sure when I'll be paid.

Another income issue the hubby and I wrestle with is year-end payouts from our investments. In good earnings years, that really bumps up our overall estimated tax responsibilities. And it all comes in the final estimated tax reporting quarter.

We could use what's known as the annualized income installment payment method that allows you to adjust your 1040-ES payments to account for income fluctuation. In our case, say we figured we'd owe $10,000 in estimated taxes. But the bulk of those taxes would be due on income earned in the last half of the year. So we would, and this example is for illustration purposes only, pay:

• $500 with our first 1040-ES payment on my paltry freelance income through March;

• $500 on equally weak earnings for the second payment period;

• $3,000 with our third 1040-ES payment to cover pay I finally received from deadbeat slow-paying clients in July and August; and

• $6,000 with our 1040-ES voucher #4 to account for my major client's more timely payments September through December, as well as our investment income.

Making annualized payments is more complicated and requires more paperwork. But it has the advantage of allowing you to make estimated payments when you actually have the money that's being taxed in hand.

However, being fans of uncomplicated, we make the four equal installments. Yes, the IRS then gets some of our money early, but with the crappy interest rates on savings right now, we're not losing that much and we're gaining less hassle. That's worth a lot more to me, at least right now.

Sailing for a tax harbor: There's also another factor you to consider, especially if you don't want to crunch exact numbers. It's the prior-year tax safe harbor. 

Here you don't have to worry so much about what you think you might make or owe. Instead, you rely on your total tax amount from the year before. As long as your tax payments, both withholding and estimated discussed earlier, are at least the same as (or 100 percent per the IRS instructions) that prior-year amount, you're good in Uncle Sam's eyes.

So if your total tax last year was $10,000 and after accounting for any withholding (including your spouse's if you file jointly), estimated tax payments and credits, you ended up writing a check for $1,200, it's the $10,000 amount, not the $1,200, that you must meet to navigate the safe harbor.

Just wanted to make that clear. To avoid added attention (and payments) your estimated payments etc. must total $10,000 just like last year.

Using that $10,000 prior year total tax amount, 110 percent would be $11,000. That $11,000 is the amount of estimated (and other) tax you need to pay to ensure that you don't run into any penalties when you ultimately file your return.

This article from Fairmark uses some dated examples, the but the process remains the same.

The Wandering Tax Pro discusses the safe harbor issue.

This SmartMoney story provides an estimated tax payment overview, as does this piece I wrote for Bankrate.

As for the figuring, the Form 1040-ES material has a worksheet. Most tax prep software also can help you run the numbers.

This post was edited Sept. 14, 2011,
to remove specific, dated year references.