(Guest Post by David Bakke)
As someone who is relatively new to the world of entrepreneurship, I recently began making quarterly tax payments for the first time. Figuring out what to pay, when to pay it, and how to submit your payments is certainly a learning process.
Being self-employed has enough of its own difficulties and challenges, so don’t add to them by irking the IRS. Taxes are not something to be swept under the rug – penalties do apply if you don’t make timely payments.
How to Calculate Your Estimated Tax
If you are an established entrepreneur, use your past income to estimate quarterly tax payments with these three steps:
- Determine Your Tax Rate Based on Last Year’s Return. Divide the amount of taxes you paid (found on line 43 of your 1040) by your Adjusted Gross Income, or AGI, (found on line 37) to determine your base percentage. If you expect to make more this year, add 1% to 2% to your base percentage per every $500 increase in revenue.
- Multiply This Year’s Projected Income by Last Year’s Base Tax Rate. This projects the total tax you will owe this year if your earnings estimates are accurate.
- Divide Total Estimated Tax by Four to Determine Your Payment. This calculates your quarterly estimated tax payments.
If you are a rookie entrepreneur, however, consider this approach:
- Estimate Your Annual Income. Determine your income after the first quarter of the year and subtract all of your business expenses and deductions. If you expect your income and expenses to stay relatively constant throughout the year, multiply this number by four.
- Determine Your Self-Employment Tax. Next, multiply your estimated annual income by 92.35%, then by 15.3% to project your self-employment tax for the year. Deduct half of your self-employment tax from the income you determined above. This is your estimated AGI.
- Determine Your Quarterly Estimated Tax Payment. Lastly, determine and apply last year’s base tax rate (as above) to your estimated AGI. Then, to that number, add your self-employment tax to determine your estimated annual tax. If this number is less than $1,000, you do not need to pay estimated taxes quarterly. Otherwise, divide the number by four to arrive at your quarterly estimated tax payment.
How to Submit Quarterly Tax Payments
There are two ways to pay quarterly estimated tax. First, you can mail your estimated tax payment to your local IRS servicing center using Form 1040-ES. Make your check payable to the “United States Treasury” and include your social security number on your check.
The alternative way is to use the Electronic Federal Tax Payment System (or EFTPS). You can set up automatic drafts to pull estimated tax payments from your bank account each quarter, or you can make one-time tax payments online. You will also have full access to your payment history through this website. However, you need to register first to receive a PIN in order to use the system. Make sure to register well before the due date of your first quarterly payment, as it will take at least 14 days to receive your PIN. In fact, the PIN I requested took more than two weeks to arrive, so I had to make my first payment through regular mail and barely got it in on time.
Also be aware that the IRS’s schedule of “quarterly” tax payments is somewhat counter-intuitive. Ordinarily, you might expect a quarterly schedule to be evenly broken down into four consecutive three-month periods. Not so here.
The first quarter consists of the expected three months. However, the second quarter consists of only two months: April and May. Moreover, the fourth quarter consists of four months: September through December. This schedule can be particularly confusing to those new to “quarterly” tax payments. Know it well to avoid late penalties.
To further assist you, here is a schedule of when these payments are due:
- Q1: Income gained from 1/1 through 3/31; due 4/17/2012
- Q2: Income gained from 4/1 through 5/30; due 6/15/2012
- Q3: Income gained from 6/1 through 8/31; due 9/17/2012
- Q4: Income gained from 9/1 through 12/31; due 1/15/2013
You are not required to make the final tax payment if you plan to file your return by January 31, 2012 and pay the entire balance due.
The process of making quarterly tax payments can be confusing and time consuming, but it’s absolutely necessary to avoid trouble with the IRS. The penalty for not making timely quarterly tax payments can be as much as 9%. I didn’t make any quarterly payments in 2010 and ultimately paid a penalty of more than $300.
Remember, you don’t have to make quarterly tax payments if you expect to owe less than $1,000 in annual taxes, so make sure you keep records of all of your business expenses and take advantage of tax deductions for small business owners. Claiming all deductions for which you’re eligible can significantly minimize your tax liability, and is one of the great advantages of being self-employed.
What are your experiences with self-employment taxes? What tips can you suggest to keep organized to make timely, accurate payments?
David Bakke owns an online reselling business and shares his insights on personal finance and money tips on Money Crashers.
(Photo by DonkeyHotey)