Estimated tax payments – to pay or not to pay? This is a good question. It really depends on each person’s financial situation. The general rule is a big fat “YES;” however, there may be really good reasons not to pay, depending on your overall financial plan. The IRS still wants their money; however, penalties levied by the IRS in the past 10 years have jumped nearly 33% to encourage taxpayers to pay on time.
The United States tax system is a ‘pay as you earn’ system, which means that as income is earned, taxes should be paid. In most cases, the ‘pay as you earn’ idea happens behind the scenes through withholding. When you are a regular employee, tax is withheld and submitted on your behalf throughout the year.
For those who earn money from other enterprises, you need to worry about making estimated tax payments if you expect to owe at least $1,000 in taxes for the year. The IRS expects you to pay your tax liability evenly over the year and has set up due dates of April 15, June 15, September 15 and January 15 (of the next taxable year). If your state has an income tax, you may need to make those payments as well. If you do not pay on time, they will levy a penalty either on your tax return when prepared or will send you an IRS penalty notice if not reported correctly on your return. If most of your income is earned at one specific period or quarter, you can actually tell the IRS that by filing out an Annualized Estimated Tax Worksheet and attaching it to your return. You will then not be responsible for paying estimated taxes on this income throughout the year since it isn’t earned until a specific period. If you don’t fill this out, the IRS will assume it is earned evenly throughout the year.
Or not to pay?
Some people feel they can earn more than the penalties by investing their would-be tax payments and collecting earnings on those funds. The IRS charges a 4% penalty for underpayment of estimated payments but because your tax liability is due evenly over the year, it ends up being an effective interest rate 2.5% on your total tax liability.
As an extremely simplified example, let’s say your total tax liability is $100,000 for the year which means you should be making estimated tax payments of $25,000 each quarter. The penalties would be $1,000, $750, $500 and $250 for the first, second, third and fourth quarters respectively. The penalty, in total, would be $2,500 which is an effective rate of 2.5%. I hope you are making more than 2.5% on your investments! Another thing to consider is the risk of your investment because let’s face it – you still have to pay your taxes on April 15. But, perhaps by thinking about the whole financial picture, you can earn a little money before you do!