What Is Annualized Income?
Annualized income is an estimate of the sum of money that an individual or a business generates over a year's time. Annualized income is calculated with less than one year's worth of data, so it is only an approximation of total income for the year. Annualized income figures can be helpful for creating budgets and making estimated income tax payments.
Understanding Annualized Income
Annualized income can be calculated by multiplying the earned income figure by the ratio of the number of months in a year divided by the number of months for which income data is available. If, for example, a consultant earned $10,000 in January, $12,000 in February, $9,000 in March and $13,000 in April, the earned income figure for those four months totals $44,000. To annualize the consultant's income, multiply $44,000 by 12/4 to equal $132,000.
How Estimated Tax Payments Work
Taxpayers pay annual tax liabilities through tax withholdings and by making estimated tax payments each quarter. There are many sources of income that are not subject to tax withholding. Income from self-employment, interest and dividend income and capital gains are not subject to tax withholdings, along with alimony and some other sources of income that may be reported to a taxpayer on Form 1099. To avoid a penalty for tax underpayment, the total tax withholdings and estimated tax payments must equal to the lesser of 90% of the tax owed for the current year or the full tax owed the previous year.
Examples of Annualized Income That Fluctuates
Computing estimated tax payments is difficult if the taxpayer’s income sources fluctuate during the year. Many self-employed people generate income that varies greatly from one month to the next. Assume, for example, that a self-employed salesperson earns $25,000 during the first quarter and $50,000 in the second quarter of the year. The higher income in the second quarter indicates a higher total level of income for the year, and the first quarter’s estimated tax payment is based on a lower level of income. As a result, the salesperson may be assessed an underpayment penalty for the first quarter.
Factoring in the Annualized Income Installment Method
To avoid the underpayment penalties due to fluctuating income, the IRS Form 2210 allows the taxpayer to annualize income for a particular quarter and compute the estimated tax payments based on that amount. Schedule AI of Form 2210 provides a column for each quarterly period, and the taxpayer annualizes the income for that period and computes an estimated tax payment based on that estimate. Using the salesperson example, Form 2210 allows the taxpayer to annualize the $25,000 first quarter income separately from the $50,000 second quarter income.