When you work for yourself, you don't have an employer to take taxes out of your paychecks for you. Instead, you need to withhold your own taxes and send money to the IRS periodically throughout the year. This requires that you figure out how much you should send, which means estimating future income.
What You Owe
The IRS doesn't care whether you earn your income at a company or from self-employment. It just wants to get your taxes on your income as you earn it. If you are self-employed, its rules specify that you need to make estimated tax payments that equal 90 percent of the taxes you end up owing for the year; no more than $1,000 less than what you end up owing for the year; or 100 percent of the taxes you paid in the preceding year, whichever is less. For example, if you paid $5,000 in taxes last year and will end up owing $7,000 this year, you will need to pay at least $5,000 of estimated taxes this year. If you paid $9,000 last year and your income goes down so that you will owe $7,000 this year, your estimated tax payments will need to equal at least $6,000 to avoid penalties. The upshot of this is that the IRS wants to see you make payments that are pretty close to what you will end up owing, but gives you a bit of leeway.
The IRS includes a worksheet with the 1040-ES form that you can use to estimate what your total tax liability will be for the year. The form starts with your best guess of what you will earn this year and helps you to estimate your credits and deductions to see how they will impact your total tax liability. While every year might be different, the IRS recommends using your previous year's tax return as a guide to what your deductions, credits and income will be in the coming year.
Sending in Estimated Taxes
You have to send in four estimated tax payments, with form 1040-ES attached, per year. The IRS provides the payment dates in the instructions to the form. If your income changes during the year, you can adjust your estimated tax payments up or down so that, at the end of the year, you have paid enough in. Furthermore, the IRS will also let you pay online and even make multiple payments during the quarter, as long as what you have paid adds up to what you owe for the quarter.
Penalties for Non-Payment
Not paying estimated taxes, or making less than the required payment amount, can leave you open to penalties from the IRS. It sets the penalty level yearly. According to legal publisher Nolo, you must pay the taxes due plus a percentage penalty for each day your estimated taxes went unpaid. The penalties have usually ranged from 6 to 8 percent of the unpaid taxes per year, adjusted for when the quarterly payment would have been due. In other words, a skipped April payment will carry more penalty than a skipped payment due at the end of the year.
The IRS may waive the penalty if you didn't pay the estimated taxes because you were a victim of a casualty, disaster or other unusual circumstance. According to the IRS website, it may also waive the penalty if "you retired (after reaching age 62) or became disabled during the tax year for which estimated payments were required to be made, or in the preceding tax year, and the underpayment was due to reasonable cause and not willful neglect."
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