Why You Should Be Paying Estimated Taxes & How to Calculate Them
As a service based business owner, you likely pay close attention to all the financial aspects of your business. Income and expense numbers make up a significant portion of company financials, and also are instrumental in calculating estimated tax payments. In this article, we will discuss why you should be paying estimated taxes and some methods to calculate them.
What Are Estimated Tax Payments?
Estimated tax payments are tax payments made to the IRS based on the amount of income earned over a certain period. While most businesses need to pay estimated taxes, if you believe your federal tax bill will be less than $1,000 after taking the proper tax deductions and credits, you do not need to make estimated tax payments for that year.
Estimated tax payments are collected to cover Medicare and Social Security taxes that W-2 wage earners (employees) automatically have deducted from their paychecks.
A good rule of thumb regarding who needs to make estimated tax payments is that if your income does not come with regular withholdings, you likely need to make estimated tax payments.
For example, suppose you are self-employed as a landscaper. The payments you receive from clients are for services rendered, and clients do not withhold any amounts for taxes. In this situation, you will have to calculate the appropriate estimated tax payments and send them into the IRS.
How to Calculate Quarterly Tax Payments
Now that we have discussed who needs to make estimated tax payments, let’s discuss some simple ways to ensure the amount you send to the IRS is calculated correctly.
Steady Income Method
The steady income method for calculating estimated tax payments is based on the idea that your income is steady from year to year. Because income amounts do not vary much from period to period, using a previous period’s income to make estimated payments is valid.
For example, suppose your service based business has earned $50,000 each year for the past five years. Additionally, income remains consistently around $12,500 per quarter. Based on these numbers and a marginal tax rate of 25%, you can estimate your total tax bill for the year of $12,500. Finally, dividing $12,500 by four gives you an estimated quarterly tax payment of $3,125.
Changing Income Method
If your service-based business is seasonal or experiences significant changes in earned income over the course of the year, the steady income method will not be very useful. Instead, your company should use the changing income method
The changing income method uses income already earned during the year to make estimated tax payments.
For example, suppose your service-based business earned $10,000 in the first quarter and $60,000 in the second quarter. You can see that projecting the first quarter’s income to estimate yearly tax liability will not yield a good result.
Instead, you simply use the $10,000 from the first quarter and $60,000 from the second quarter to calculate corresponding estimated tax payments.
You may be wondering why any business would use the consistent income method as the changing income method has the advantage of using actual numbers. One reason is simplicity: if a company knows to a high degree of accuracy its income over the relevant period, using this figure to calculate estimated tax payments will save both time and money.
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How Do I Properly Make Estimated Tax Payments?
Many popular tax preparation programs have features that help with making estimated tax payments.
The IRS requires taxpayers to file a form 1040-ES to record estimated income and projected tax bill. If your estimated payments turn out to be more or less than the payments sent in, you can file an additional 1040-ES to correct any errors.
Overpayments are often applied to future quarterly tax payments to offset the future tax liability.
Possible Penalties
Because estimated tax payments are not withheld automatically, it may be tempting to delay or even not make required estimated tax payments. However, the IRS does impose possible penalties for failure to pay or delayed payments.
The IRS does provide relief for good causes, such as natural disasters and other extenuating circumstances.
Payment Dates
For 2022, estimated tax payments must be sent in by the following dates:
April 18th, 2022
June 15th, 2022
September 15th, 2022
January 17th, 2023
We hope this short article has helped explain estimated tax payments and how to calculate/remit them. Here are some additional tips that can make the process run smoothly:
Keep your accounting books updated and current
Use reminders for due dates
Consult with a tax professional before sending in your first payments
For more information on tax preparation and other services we provide, check out the rest of the Tatum Accounting website!
