Definition
Estimated tax refers to an anticipated amount of tax liability that individuals or businesses believe they will owe to the government in a specific fiscal year. This is typically based on their income, withholdings, and deductions. It’s paid quarterly or monthly to avoid a large tax bill at the end of the fiscal year.
Key Takeaways
- Estimated tax is a method used to pay tax on income that is not subject to withholding. This can include earnings from self-employment, interest, dividends, rent, or alimony.
- Individuals and businesses are required to estimate and pay these taxes. If not managed correctly, underpayment can lead to penalties by the Internal Revenue Service (IRS).
- Estimated tax payments are made quarterly, with due dates generally falling in April, June, September, and January.
Importance
Estimated tax is an important financial term as it refers to the method used to pay tax on income that is not subject to withholding, including income from self-employment, interest, dividends, rent, and alimony.
It is crucial in financial planning and management because it helps individuals and businesses estimate their tax liability for the year and make regular payments to avoid underpayment penalties.
Furthermore, estimated tax payments allow taxpayers to spread their total tax liability over the year, making it easier to manage their cash flow.
Understanding and effectively utilizing this system can result in significant financial benefits.
Explanation
Estimated tax is primarily used as a method for taxpayers, especially those who are self-employed, to pay tax on income that isn’t subject to tax withholding. This can include earnings from self-employment, dividends, rent, a sole proprietorship, partnership, S corporation, and income from sharing economy activities.
Certain taxpayers must make estimated tax payments throughout the year. This system ensure these taxpayers are paying their fair share towards their annual tax responsibilities as their income comes in, rather than in a lump sum at the end of the year.
The purpose of estimated tax is to avoid underpayment penalties. If a taxpayer earns a considerable amount of income not subject to withholding, they would owe a significant amount of taxes at the end of the year.
If too little is paid throughout the year, the taxpayer may also owe a penalty for underpayment. Therefore, paying estimated taxes essentially works to the taxpayer’s benefit, allowing them to spread their tax payments throughout the year, and helps ensure that they’re not hit with hefty fines or penalties when it comes time to file.
Examples of Estimated Tax
Self-Employed Professionals: Independent contractors, freelancers, and self-employed individuals often utilize estimated tax payments. They typically don’t have employers withholding tax from their income, therefore, they need to estimate their tax liability and make quarterly payments to the IRS. This can be based on their estimated income for the year from various sources such as providing freelance graphic designing, counseling services, or operating a home-based business.
Landlords: Individuals who earn income through rental properties also have to pay estimated taxes. Suppose a landlord rents out several properties and that’s their primary source of income. They will need to estimate their tax for the year based on the rental income they are expecting to receive, subtracting their deductible expenses, and then make periodic tax payments throughout the year.
Investors: Individuals with significant investment income, such as from stocks, bonds, or mutual funds, may need to make estimated tax payments. Investments often generate income in the form of dividends or interest, which is not subject to withholding. As such, investors would have to estimate their potential tax liability and make appropriate payments. For instance, a retiree living off their investment income will need to make estimated tax payments based on that estimated income.
FAQs for Estimated Tax
What is an estimated tax?
Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, business earnings, interest, rent, dividends and other sources. The IRS mandates that everyone who is required to file a tax return, and who expects to owe at least $1,000 in tax for the year, must make estimated tax payments to the IRS.
Who pays estimated taxes?
Estimated taxes are typically paid by self-employed individuals, but they may also be paid by any taxpayer who does not have enough tax withheld from their salary or pension. It can also apply to individuals who have income from other sources not subject to withholding such as rentals, dividends, interest, capital gains, prizes and awards.
How are estimated taxes calculated?
Estimated taxes are calculated by adding up your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year. From these figures, calculate your expected tax liability, then subtract your expected withholding for the year. The remaining balance is your estimated tax payment.
When should estimated taxes be paid?
Estimated tax payments are due four times in a tax year. For most taxpayers, the four quarterly due dates are: April 15, June 15, September 15, and January 15.
How can one pay estimated taxes?
You may pay your estimated taxes through direct debit or credit card. Alternatively, you can mail your payment with a payment voucher from Form 1040-ES.
What happens if one fails to pay estimated taxes on time?
If you don’t pay enough tax through withholding and estimated tax payments, you may be charged a penalty. You also may be charged a penalty if your estimated tax payments are late, even if you get a refund when you file your tax return.
Related Entrepreneurship Terms
- Quarterly Payments
- Underpayment Penalty
- Tax Liability
- Self-Employment Tax
- Income Adjustments
Sources for More Information
- Internal Revenue Service (IRS): The official site of U.S. tax department providing all comprehensive information related to taxes, including estimated tax.
- Investopedia: A trusted online resource dedicated to investing education and financial news. It covers various terms related to finance and investment, including estimated tax.
- H&R Block: A reliable site that offers tax services and resources, including a tax information center which covers a variety of topics such as estimated tax.
- TurboTax: Provides tax tips and videos on a wide range of topics, including estimated tax. TurboTax online can also be used to calculate and file taxes, including estimated tax.
