What is Estimated Tax?

Estimated tax is a periodic advance pre-payment of taxes based on the amount of income that is earned and the amount of estimated tax liability that will have been incurred as a result. Estimated taxes are assessed on income that is not subject to any type of withholding, which includes self-employment income, dividend income, rental income, interest income, and capital gains.

Understanding Estimated Tax

Everyone is required to pay the federal government taxes on income earned. While those who are employed by a company will have taxes withheld from their pay cheques by their employers based on a completed W-4 Form, others will need to make these payments on their own directly to the government in the form of an estimated tax, rather than waiting until the end of the year to file an annual tax return. Individuals who are self-employed, investors who receive dividend income and generate capital gains, bondholders who receive interest income, and landlords who earn rental income are examples of taxpayers that must estimate the amount of taxes they owe to the government and make a payment on the estimate. Other examples of income liable for estimated tax include taxable unemployment compensation, retirement benefits, and the taxable part of Social Security benefits received.

Estimated taxes are usually paid on a quarterly basis. The first quarter is three months (January 1 to March 31), the second "quarter" is two months long (April 1 to May 31), the third is three months (June 1 to August 31), and the fourth covers the final four months of the year. The installment payments are due on April 15, June 15, and September 15 of the current year and 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. For example, self-employed individuals typically pay estimated tax on 92.35% of their net earnings. Since they are not subject to withholding tax, the IRS requires that they make quarterly estimated tax payments in order to cover their self-employment tax obligation. However, if a small business owner's net earnings is less than $400, no tax is payable. But if his or her net earnings is above $400, s/he must pay an estimated tax on the entire amount.

Key Takeaways

  • Estimated tax allows individuals or business owners to pre-pay a certain amount of income tax based on income received before the year is complete.
  • Estimated tax pre-payments are most often made on a quarterly basis.
  • Because certain individuals 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.

Estimated Tax for Business Owners

Shareholders of partnerships and S corporations must make estimated tax payments on business ownership earnings if the total of tax on built-in gains, excess net passive income tax, and investment credit recapture tax is $500 or more. Shareholders of 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 last 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 withholds from his paycheck, may be able to increase his withholding so that it equals what his tax liability would be for the entire year. In this case, he will not need to pay estimated taxes on his 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. An individual that pays estimated tax cannot file Form 1040EZ, Income Tax Return for Single and Joint Filers With No Dependents.