What Is the Annualized Income Installment Method?

The annualized income installment method calculates a taxpayers' estimated tax installment payments and helps to decrease underpayment and penalties incurred due to their fluctuating income. Taxpayers must pay quarterly installments of their estimated tax in amounts figured by the regular installment method. When a taxpayer has a fluctuating income it often causes them to underpay on the quarterly estimates leading to underpayment penalties. Through the use of the annualized income installment method, taxpayers may more accurately estimate their taxes.

Annualized Income Installment Method Explained

The purpose of the regular installment method is to figure quarterly tax installments, which is done by dividing the annual estimated tax into four equal segments. The resulting payments will timely pay the quarterly estimated taxes of taxpayers with a steady income but does not work as well for those taxpayers with fluctuating income. 

Consider, for example, taxpayers Jane and John. Each of them owes $100,000 in annual estimated tax, and each of them makes estimate payments in four $25,000 installments. Jane evenly earned her income, 25% each quarter, so the quarterly portions paid her estimated tax in full and on time. 

John's earnings were uneven, with each quarter being, 0%, 20%, 30%, and 50%, respectively. John’s first two installments overpaid his estimated tax liability by $25,000 and $5,000. His last two installments underpaid it by $5,000 and $25,000. The two underpayments subjected John to four underpayment penalties. Two penalties are for failing to pay in full, and two penalties are for missing the due dates. Fortunately, John can get penalty relief. The annualized income installment method allows John to refigure his installments, so they correlate to his income as he earns it. 

It does so by annualizing John’s installments over four overlapping periods. Each period begins on Jan. 1 and end, one after the other. The first period ends on March 31, the second ends on May 31, the third on Aug. 31, and the fourth period ends on Dec. 31. Each period includes all the previous periods, with the final period encompassing the entire year.

  • 1st Quarter: Jan. 1–March 31 tax due on 0% earnings
  • 2nd Quarter: Jan. 1–May 31 tax due on 0%+20% earnings
  • 3rd Quarter: Jan. 1–Aug. 31 tax due on 0%+20%+30% earnings
  • 4th Quarter: Jan. 1–Dec. 31 tax due on 0%+20%+30%+50% earnings

John now has four installments of different amounts that, when added together, equal his full annual estimated tax. John's refigured installments are now timely paid, with all four of his underpayment penalties abated.

IRS Publication 505 has forms, schedules, and worksheets that guide taxpayers desiring to refigure their installments using the annualized income installment method. The annualized method can be calculated using IRS form 2210. However, figuring installments this way is complicated and best done on an IRS worksheet by your favorite tax professional.