If you're earning money from an employer, you pay income taxes along the way through withholding. But if you also earn "non-wage" income, you may need to pay estimated taxes as well. Every three months, millions of people have to guess the right amount of money to send to the IRS to keep current on their tax bill. If you under-estimate, there could be an IRS penalty looming.
Paying estimated tax can be a challenge. Many freelancers and investors have only a vague idea of how much they're going to earn throughout the year and may not have the funds set aside to pay a hefty bill every three months. The result can be a big tax liability when you finally file on April 15 -- as well as a penalty for under-estimating the amount you were supposed to pay. Fortunately, the IRS grants a break to those who owe less than $1,000 in tax, or paid at least 90 percent of their tax liability through the estimated payments.
The Short Method
The IRS method for figuring the penalty on underpayment of estimated taxes is appropriately complicated and confusing. You must use Form 2210, and select either a Short Method or a Regular Method. You can use the Short Method if you paid no estimated tax or made equal payments of estimated tax in every quarter. In the Short Method, you add up all estimated tax payments and withholding amounts, subtract them from the total tax you owe, and multiply the result by .01995. Basically, you're paying a penalty of 1.995 percent on the underpayment.
For the Regular Method, Form 2210 comes with detailed instructions -- and you'll need them. Calculating your penalty using the Regular Method involves nine separate line entries, times four quarterly payment periods, as well as a detailed worksheet. Taxpayers with a taste for spreadsheets and a good calculator might enjoy this chore, but if your underpayment is relatively small and your time is valuable, a better alternative is to allow the IRS to make the calculation and send you the bill. If you're wrong, they'll be correcting your figures anyway.
Do-it-yourself Penalty Figuring
Some unfortunate taxpayers will not have the alternative of having the IRS figure their estimated-tax penalty and interest. The IRS requires you to calculate the under-withholding penalty yourself if you are requesting a waiver of the penalty, or if you are using the "annualized income installment" method, which is the alternative to using four equal quarterly payments. But you can escape the estimated tax penalty entirely if you failed to make payments due to a casualty loss or a natural disaster; or if you retired in the tax year or the year before, are at least 62, and can show good cause why you missed the estimated tax numbers.
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