Did you know you are required to prepay at least 90 percent of your taxes before you file your return? Many taxpayers have income tax withholdings from their job that allows them to meet the prepayment requirements, but for those who don't have withholdings or are unable to meet their prepayment obligation through withholdings, the IRS allows taxpayers to estimate their annual income tax liability each quarter and make a payment of one-fourth the estimated liability.
What type of income usually generates estimated tax payments? Certain types of income are not subject to withholding. This includes income from self-employment, such as contract work and sub-contract work, as well as investment income, such as interest and dividends, just to name a few. Since these are all forms of income, you are required to pay income tax on these earnings.
If you do not pay enough through estimated tax payments, you may be charged an "under withholding penalty" for each quarter that you underpaid when you file your taxes. There are two easy ways to avoid this penalty: make sure you prepay 100 percent of last year's tax liability or 90 percent of this year's.
The simplest method of ensuring you will not have to pay an underpayment penalty in 2013 is to make sure your combination of federal income tax withholdings and estimated taxes are equal to or greater than your 2012 total tax amount from your federal income tax return. You can pay your payment all at once on April 15, or you can split your payment into four equal parts and make an Estimated Tax Payment each quarter by April 15, June 15 and September 15 of the current year and January 15 of the next year.
If you expect to have a substantial increase or decrease in your income this year, or if your income fluctuates throughout the year, you may want to estimate your income and taxes for the year each quarter and determine your estimates this way.
Determining your annual estimated income tax quarterly can be time consuming and confusing. First, you must determine your income for the year through the end of the quarter in question and then estimate the full year income based on what you have received so far. Next, you must determine your deductions for the year based on what your expenses have been to date and estimate them for the full year based on what you have spent so far. In both cases, you may be aware of additional income or expenses that are different from what you have received or spent so far, which should also be included in your calculations.
If you are self-employed, you should include all income received from the beginning of the year through the end of the quarter.
"But wait, I have deductions," you say. "Don't they lower my tax liability?" Yes. When you are projecting your income for the year, you should also be calculating your expected deductions. If you're not sure what you can or cannot deduct, here are a few items to consider:
Healthcare Costs
Up to 100 percent of medical insurance costs you pay for yourself, your spouse, and your dependents may be deductible as an income adjustment. The deduction is subtracted from your total income and applies whether or not you itemize. As a self-employed taxpayer, you also have the option of setting up a health savings account (HSA). But that's a story for another day.
Travel
If you use your vehicle for business purposes, you may be able to deduct expenses associated with this use. To do this, you must keep track of total miles driven for the year, total business miles driven and actual expenses, such as gas, maintenance and insurance, if you don't want to use the standard mileage rate.
Operational Costs
Tools and necessary equipment are deductible items. Additionally, fees paid for renewing and maintaining your professional licenses or certifications can be deducted. As with most businesses, communication expenses such as phone, fax and Internet bills can be reported as deductions. Clothing is deductible only if it is designed specifically for the jobs; for instance, scrubs for nurses.
Home Office
If you are operating your business from your home, additional deductions may be available to you. The following questions will help you determine whether you can deduct the business use of your home:
- Is this part of your home used regularly and only in conjunction with your business or work?
- Is this your primary place of business?
- Is this where customers and clients meet with you?
- Is this where you administer/manage your trade or business?
- Is this where you store product samples?
If you answer yes to any of these questions, you may be able to deduct certain expenses for the business use of your home. The same tax benefits may apply if you maintain a separate structure for your business.
Self-employed taxpayers must pay federal income taxes and self-employment taxes on their net profit. The amount of federal taxes for which a taxpayer is responsible can be determined by filling out a Form 1040 using projected income for the year. Once you determine your tax liability, divide that by four. That's what you should pay each quarter (if you don't decide to use your prior-year liability as your guide). You should do the same for any state or local income taxes you must pay as well. This is fairly straightforward if your income is pretty consistent throughout the year. If it fluctuates, you may want to consider talking to a professional to make sure your quarterly payments are covering you.
So while April 15 is commonly accepted at "tax day," for many taxpayers and especially small business owners, freelancers and self-employed professionals, there are other important "tax days" to keep in mind.