Man opening mail from IRS with shocked look on his face
If you have income other than a steady paycheck, you need to be aware of estimated taxes. Read this estimated taxes explained and avoid surprise tax penalties.

Once you leave the world of a steady paycheck, you need to be aware of estimated tax payments. Read this article to see estimated taxes explained and avoid surprise tax penalties.

We Live in a Pay As You Go Tax System

The IRS operates on a pay-as-you-go model, which means you’re expected to pay taxes on your income as you earn it throughout the year.

This concept of pay-as-you-go means that you need to pay most of your taxes during the year as you receive income. You can’t just wait until the end of the year or the next year when you do your taxes to pay tax. If you wait until year-end, you may face penalties and interest in addition to the tax you owe.  According to Investopedia, the IRS underpayment penalty was 7% for most underpayments in 2023.1 Penalties for making no payments are even higher.  The November 2023 IRS news release showed the interest rate for underpayment is 8%. 2

If you are part of the gig economy or your income does not come from a steady paycheck, keep reading estimated taxes explained.

Estimated Taxes Explained

When you have withholding from a paycheck, pension, or social security you are paying tax as you receive income.  You just need to make sure you have the proper withholding.  Usually, no need to pay estimated taxes in this case.

In contrast, if you do not receive income where you have automatic tax withholding, you need to stay informed about estimated taxes.  Specifically, you need to make timely payments to avoid penalties.  This applies to freelancers, self-employed individuals, and those of us without jobs but who have income from interest, dividends, and capital gains.

Estimated taxes are spread across four quarterly payments during the year. However, the payments are not due at the end of each quarter.  For income earned in 2024, the payment due dates are:

  1. April 15
  2. June 17
  3. September 16
  4. January 15 (2025)

There is an IRS form with a worksheet you can use to calculate your estimated taxes, Form 1040-ES: Estimated Tax for Individuals

The Safe Harbor Rule to Avoid Underpayment Penalties

The IRS assumes income is earned evenly throughout the year even if your income is not. For those of us who have a hard time forecasting income for the year ahead, the safe harbor rule is an easier way to determine the amount of estimated taxes to pay.

For most of us, you won’t face an underpayment penalty if:

  • You pay at least 90% of the tax you owe for the current year, or
  • You pay 100% of the tax you owed for the previous tax year, or
  • You owe less than $1,000 in tax after subtracting withholdings and credits.

For high-income taxpayers, which means if your Adjusted Gross Income (AGI) on the previous year’s return is over $150,000 (over $75,000 if married filing separately), you must pay the lower of:

  1. 90% of the tax shown on the current year’s return, or
  2. 110% of the tax shown on the return for the previous year

Whatever number you come up with using the safe harbor rule, you divide it by four.  That is what you send each quarter as an estimated tax payment.

Remember that your state may have different estimated tax payment rules from the federal rules. 

Uneven Income Through the Year

Earlier in this article, it was mentioned that the IRS assumes the income was earned evenly throughout the year.  If you are making Roth conversions in the fourth quarter your income may be larger in that quarter.  Reading a Wall Street Journal article last week, I discovered there is a way to tell the IRS your income varied during the year. 

Form 2210 is often used as a worksheet to determine the amount of underpayment penalty.  Additionally, Form 2210 includes Schedule AI Annualized Income Installment Method.  The Schedule AI provides you with a way to show that your income was not received evenly throughout the year and that you made payments based on the actual taxable income during each period.  This can be helpful if you have an uneven income throughout the year.  For example, if you are making a Roth conversion during the fourth quarter or have a large capital gain.  Also, if you run a seasonal business.

Other Ways to Avoid Underpayment Penalties

When paying estimated taxes, the IRS assumes the income was earned evenly throughout the year.  In contrast, withholding is assumed to be even throughout the year whenever the actual payment date is.  This rule applies to withholding on paychecks, traditional IRA withdrawals (including RMDs), Social Security payments, and pension payments.

So that if you have income that you can change your withholding, this gives you another option.  You can raise your withholding on a paycheck or IRA payout enough to cover the tax—even in December.  As a result, there is no estimated tax penalty.

This is not avoiding the penalty, but under certain circumstances, the IRS may waive underpayment penalties.  It is best to consult your tax advisor regarding waivers.

Estimated Taxes Explained Conclusion

Remember, staying informed about your tax obligations and making timely payments can save you from surprises and penalties come tax season! 

You can use the safe harbor rule to estimate the amount of estimated taxes to pay.

Using Form 2210 allows you to make estimated tax payments in the same quarter as your income when your income varies by quarter.

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  1. 1 Tax Underpayment Penalty: What It Is, Examples, and How to Avoid One (investopedia.com) ↩︎
  2. 2 Interest rates remain the same for the first quarter of 2024 | Internal Revenue Service ↩︎

Published on February 19, 2024

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