Oh, taxes. How we love to hate them, and all the potentially complicated dos and don’ts. Things were so much easier when we were regular employees and didn’t need to worry about such things like estimated payments. Upside of being your own boss: taking Tuesday afternoons off because you feel like it. The downside? Figuring this sh*t out.
Don’t worry. I’ve got your back.
First thing’s first:
What’s an estimated tax payment?
Back in the day when you were an employee, you had money taken out of every paycheck for income taxes. This is because the IRS requires you to pay your taxes throughout the year. (Just like you like getting paid every two weeks instead of one lump sum at the end of the year, so does Uncle Sam.) When you stop working a “regular” job and going into business for yourself, you’re not getting a regular paycheck with taxes being withheld. Instead, you’re responsible for making what are called estimated tax payments. Instead of having funds withheld from a (non-existent) paycheck, you pro-actively pay the government some money each quarter.
Do I need to pay estimated taxes?
Short answer: Probably!
Long(ish) answer: If you’ll owe at least $1000 in federal taxes this year, yes, you need to pay estimated payments. And believe me: it doesn’t take a huge amount of income to generate $1000 in taxes. In my first year of business in 2018 I brought in about $12,000 in income. Combine that with some investments income (interest, dividends, etc), and my tax bill was $1,800. So, yeah. You're probably (hopefully!) going to have to pay estimates payments!!
One situation where you don’t need to make estimated payments: If you (or a spouse) have a regular job and you have enough withheld from those paychecks to cover the tax on the your business income. So, if your spouse works a 9-5 job, you guys can do the math and have them increase their withholding to cover your business income taxes.
How much do I need to pay? (And when?)
The an easy way to land on a number is to base it off last year’s tax return. Look at the total tax your household paid, and aim to pay that same amount, perhaps a bit more if your business is growing (which hopefully it is!).
For example: Your household paid $5000 in taxes last year. After looking at your spouse’s paycheck, you do a bit of math and figure out that they’ll have $3500 withheld for federal taxes. Which leaves you with $1500 that should be paid via quarterly estimated payments.
Or, you can use this handy calculator to help you figure out how much to set aside each month!
You can make your payments on the Electronic Federal Tax Payment System.
What happens if I don’t pay?
If you don’t pay the IRS 100% of what you paid them last year (or, alternatively, 90% of the tax you end up owing for this year), you’ll have to pay a penalty plus interest on your underpayments. It’s a bit complicated, but in general, there are two parts to this:
Failure-to-Pay Penalty: Once the estimated payment due date has passed (and you don’t submit a required payment!), the IRS penalizes you 0.5% of the amount you owe. For each month you don’t pay, that rate goes up. (But it gets capped at 25%.)
Interest on your missed payments: Not only does the IRS charge you a penalty for not paying, but they also charge you interest on the amount you didn’t pay. It varies from quarter to quarter but is generally the federal short-term interest rate plus 3%. As of Q1 of 2024, the IRS is charging 8% interest on estimated tax payment underpayments.
And in case you’re thinking “Oh, I missed this quarter’s payment, I’ll just pay more next quarter,” unfortunately, that’s not the smartest move. As I mentioned above, the failure-to-pay penalty — and associated interest — are charged for each month that you don’t pay. So if you miss an estimated payment deadline, make the payment as soon as reasonably possible.
NOTE: I’m not a CPA or a licensed tax professional. The above is for informational purposes only. Consult a CPA or do your own investigating to find out if you personally should be submitting estimated tax payments.
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