What Is Estimated Tax?

Estimated tax is a quarterly payment of taxes due based on the filer’s reported earned income for the period. Most of those required to pay taxes quarterly are small business owners, freelancers, and independent contractors, who do not have taxes automatically withheld from their earnings.

Estimated taxes may be made for any type of taxable income that is not subject to withholding, including earned income, dividend income, rental income, interest income, and capital gains.

The Internal Revenue Service (IRS) requires quarterly estimated tax payments to be filed by those who have income that is not subject to automatic withholding. The taxpayer then files the usual tax paperwork for the full year and pays the balance due or requests reimbursement for an overpayment.

Key Takeaways

  • Estimated tax allows individuals or business owners to prepay a certain amount of income tax based on income received before the year is complete.
  • Estimated tax prepayments are made on a quarterly basis.
  • For those individuals who are not subject to automatic tax withholding (e.g., self-employed), estimated tax helps smooth income tax payments so that there is no surprise lump sum due at tax filing.

Understanding Estimated Tax

Everyone is required to pay the federal government taxes as they earn or receive income during the year. In other words, income taxes are pay-as-you-go.

Those who are employed have taxes withheld from their paychecks by their employers based on the W-4 forms the employees complete. Others need to make these payments directly to the government in the form of an estimated tax, rather than waiting until the end of the year to pay when they file their annual tax return.

People who are self-employed or independent contractors, investors who receive dividend income and generate capital gains, bondholders who get interest income, writers who earn royalties on their work, and landlords who have rental income are all examples of taxpayers who must estimate the amount of taxes they owe to the government and pay that amount.

Other examples of income liable for estimated tax include taxable unemployment compensation, retirement benefits, and any taxable portion of Social Security benefits received.

Estimated taxes are usually paid on a quarterly basis. The first quarter is the three calendar months (January 1 to March 31). The second "quarter", however, is only two months long (April 1 to May 31). The third is the next three months (June 1 to August 31), and the fourth covers the final four months of the year. These installment payments are generally due on April 15, June 15, and September 15 of the current year and on January 15 of the following year.

If the estimated taxes that are paid do not equal at least 90% of the taxpayer’s actual tax liability (or 100% or 110% of the taxpayer’s prior-year liability, depending on the level of adjusted gross income), then interest and penalties are assessed against the delinquent amount.

If an individual filer’s net earnings are less than $400, no tax is payable. If their net earnings are above $400, an estimated tax must be paid on the entire amount.

Estimated Tax for Business Owners

Individuals, including sole proprietors, partners, and shareholders of S corporations, must make estimated tax payments on business ownership earnings if the total tax on built-in gains, excess net passive income tax, and investment credit recapture tax is $1,000 or more.

Corporations must pay estimated tax if the business is expected to have at least $500 in tax liability. In addition, employees who had too little tax withheld and, therefore, owed taxes to the government at the end of the previous year are responsible for making estimated tax payments.

A business owner who reports income on Schedule C and, at the same time, works for an employer who has withheld tax may be able to increase the employer’s withholding so that it equals the individual’s tax liability for the entire year. In this case, the person will not need to pay estimated taxes on the side business.

IRS Form 1040-ES is used to calculate and pay estimated taxes for a given tax year. A taxpayer who had no tax liability for the prior year, was a U.S. citizen or resident for the whole year, and had the prior tax year cover a 12-month period, does not have to file Form 1040-ES.