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Estimated Payments
Hate Them? But Pay them!
by
Eva Rosenberg, MBA, EA
So you're in business
on your own now? No more W-2's. For the first time, you have make your
own tax deposits? When do you make them? What forms do you use? Who do
you send them to?
Or you're lucky enough to have investments that are profitable - and require you to make estimated tax payments.
How much should you pay? What's the big deal if you don't make the payments?
Let TaxMama tell you that you can easily destroy your business and drain
your cash flow by ignoring the IRS rules of operation. Do you really want
to succeed in business? Well, you can't do it without really trying. So
follow all the rules!
Let's start with the basics, shall we?
Who Should Be Paying Estimated Payments?
Anyone else ....well, if you are receiving wages, you can easily talk to your tax pro about manipulating your payroll tax withholding so you never have to make estimated payments.
When Should You Be Making Those Payments?
And your first instinct is to interpret that as every three months, right?
Of course not. Don't be silly. We're dealing with tax code here. Some extremely
clever lawmaker decided that quarterly, for tax purposes, breaks down as
follows:
| 1Q |
1st Quarterly
Payment |
April
15th
|
(in 2008 it's the 16th,
when the 15th is a weekend/Federal holiday, the due date is the next working day) |
| 2Q |
2nd Quarterly
Payment |
June
16th
|
(Yes, I know! It's not three months,
only 2) |
| 3Q |
3rd Quarterly
Payment |
Sept.
15th
|
Hurrah! This really is three months
apart! |
| 4Q |
4th Quarterly
Payment |
Jan.
15th
|
You've got it! Four months, what
can I say? |
(Note: Anytime a payment falls on a weekend or Federal holiday, it's due the next working day - even if I haven't updated the chart.)
Before we get into any specifics,
here are some fundamental tips about making Estimated Tax payments. Meanwhile
the IRS has information in chapter 2 of Publication 505.
You will be using Form 1040-ES (and your state's
equivalent). Presently, you must only pay in if:
You expect to owe $1,000 or more beyond any payroll withholding.
And
1) Your withholding or other
tax credits (education, children, etc) will be less than 90% of the tax
you expect to owe on your tax return
or
2) Your withholding or other tax credits (education, children, etc) will
be less than 100% of the tax shown on your previous year's (12 month) tax return. If you expect to have losses from the business, don't worry about making estimated tax payments on the business.
Estimated tax safe harbor for higher income individuals. If your adjusted gross income for 2007 was more than $150,000 ($75,000 if married filing a separate return), your withholding and estimated tax payments must be at least the smaller of 90% of your tax liability for 2008 or 110% of the tax shown on your 2007 return (provided your 2007 return covered all 12 months) to avoid an estimated tax penalty.
My Short Method:
Use this shortcut if you expect your taxable income to be the
same or higher than it was last year. It's really simple.
Take a look at last year's return.
Look at page 2 of your 1040,
line 56 - Total Tax. Let's say it was |
$10,000 |
| From that, deduct any withholding
you have from ANY sources (wages, interest, dividends, unemployment). Say, |
3,000 |
Deduct the withholding you expect
to have
from last year's tax return: |
$ 7,000 |
| Divide the result by 4 ($7000/4) |
$ 1,750 |
Ta daaa! That's how much you should be paying each quarter.
That's it. That's all there is to it. Read no further.
"But," you ask, "what's if I only owed
$10,000 last year, but I expect to owe $20,000 this year?"
TaxMama says, "Put the other $10,000 in the bank or in a money market account and let it earn interest for you. You are welcome to wait until April 15th of next year, to send it to the IRS."
Period. No more discussion!
If you are too immature to handle your own savings, give your mother control of the account and let her hold on to it for you. Or if you're really wimpy, just break down and mail as much of the extra $10,000 to the IRS as you like each quarter. They won't turn the money down.
My Short Method breaks down when you
owed lots more last year than you expect to owe this year. You see, you
may be penalized if you don't pay in as much as last year's line 56. But, as long as you can reasonably guesstimate how much you expect to earn this year, pay enough in to cover that. How do you figure that out? Aha! That's the question.
[The IRS has a Long Way ... you can use their worksheet to figure out if
you must pay - and how much.
http://www.irs.gov/publications/p505/ch02.html#d0e5045]
You've Got the
General Idea, Let's See How it Affects You.
For organizational purposes, we'll look
at the income sources for each category:
1) People who are self-employed:
For our purposes, self-employed means, you have your own business, you
have a closely-held corporation, LLC, LLP or partnership - any entity that you control, not just a little Schedule C, home-based business.
Consideration - often overlooked when making projections - all self-employment income (from Schedule C, partnerships, LLCs and LLPs) is subject to 15.3% worth of self-employment taxes. (Social Security and Medicare)
2) People whose non-wage income is increasing (or expected to increase) in the current year.
What areas should you be looking at besides wages and business income?
Unemployment - this is taxable on the IRS return, but generally not on
the state return.
Social Security - after $25,000 of overall income, up to 80% of the SS
is taxable on the IRS return - but not on the state return.
Partnership or Trust Profits or Income - These get passed through to you
throughout the year in the form of draws. While the draws may not be taxable, your share of the entity's income is.
Rental Income - you own property or are renting out part of your house.
3) People who've done well on the stock market.
Doing well on the stock market means showing a profit. You won't be paying tax on the money you get from the sale. You will only pay taxes on the profits. (Make sure you track the costs of each stock or investment ... and be sure to add in all the dividends you reinvested.) We are not going into detail, today, on how to compute your gain or loss. You can always call your tax pro for that. (Sometimes, it gets complicated.)
There is a special computation on your tax return to separate out your
profits by long or short term. You will be paying federal rates ranging
from 10% to 28% on those long-term capital gains. Generally, these rates
are lower than your regular tax rate. Remember, all your short-term gains will be taxed at your regular rate. So, don't get too carried away with buying and selling.
Sometimes, you will get sudden, invisible gains from the mutual funds you own. It's up to you to know the investing style of the fund. (If you don't, you don't belong in it. ) If you have questions, you can call the fund. They will tell you if they expect to have lots of capital gains (which come when the fund managers buy and sell stocks). Some funds have low turnover (the managers buy stocks in solid companies to hold for the long term and don't sell the whole portfolio several times each year.)
4) People who've gotten a healthy inheritance (or other windfall), with assets that produce income.
First of all, let's dispel the initial myths quickly:
All the money you inherited is not taxable. The estate paid the taxes on
it before you got it. (Or they should have.) The lottery winnings are only
taxable to the IRS, not your state.
The insurance settlement you got for your auto accident is NOT income (unless
a portion of the settlement was specifically spelled out as replacement
of your lost earnings).
However, despite what they told you, the money you received in that sex
discrimination suit IS most likely taxable.
So, generally, all that stuff probably wasn't taxable when you got it.
But, come on folks, you've got that money now. It's invested in stocks,
bonds, mutual funds, even CD's and US Bonds. Those things generate interest
and dividends. Why are you so surprised to discover that you have to pay
tax on the money your inheritance, gift or prize earns.
I get this question all the time. It boggles the mind. Of course the dividends
and interest are taxable to you. Even if the trustee was holding on to
it FOR you, before distributing the money to you.
Nu, So What Do We Do Now?
So, now you have the four explanations of who's got to pay ES
payments. Nu, so what do we do now?
If the short method works, because your business is doing better and your
income is steadily rising...you don't need to read any further.
But, if you are like most self-employed people or most investors, your
income fluctuates. Some months, you have thousands of dollars - even hundreds
of thousands ... Other times, months go by without a dime.
There is another way to work this. You can use the "Annualized Income Installment
Method." They come with their own set of worksheets. Yes, you can compute
this by hand, but a computer is so much easier. If you need to do this,
just call your tax pro.
If you must do it yourself, here is IRS's explanation of how it works, in the form of an example.
You can see the actual worksheet.http://www.irs.gov/publications/p505/15008e07.html
Basically, the logic is that you will avoid the penalty by paying tax
only the profits your business has earned by the date each installment
is due.
TaxMama Trick: If you use this method,
make sure that you print out the Profit and Loss (P&L) report for the
time frame indicated for each installment. Along with the P&L, keep
a copy of the worksheet you filled out - and a copy of the checks and 1040-ES
vouchers you used. That way, in the event of a penalty assessment, you
can prove your case. Besides, your tax pro will need those numbers when
preparing your Y2K return.
Other Things To Watch For....
If you expect to have high levels of itemized deductions (over
$44,350 - single or $66,250 married, filing jointly) , you may find yourself facing
Alternative
Minimum Taxes (Alt Min) next year. If you have enormous patience, you can try to figure out if you will be facing that issue. Read Form 6251 or the instructions to it.
Do NOT do this at home, my friends.
All too often, I've seen people ignore the eatimated vouchers provided by their tax professionals and blithely figure out their own estimated tax payments...only to be shocked to discover that they still owe several thousands of dollars in taxes PLUS penalties
and interest - because they did not understand about SE taxes and Alt Min.
Naturally, if your income is complex enough not to fall into TaxMama's Short Method, you are probably already seeing a tax professional. Which means, that when they prepared your tax return, they probably already gave you a set of preprinted ES vouchers, with envelopes. (I know I did!) Use them!
And if your tax return is still on extension, the odds are that your tax
pro gave you the first two vouchers (for April and June). I know I sent
them to the clients who need them.
If you don't have vouchers, I put a link to them somewhere above, in this article. But, if your tax situation is complicated enough to need the worksheets or annualized method, please get help. Otherwise, you'll hurt yourself.
Remember, those do-it-yourself tax programs....? They're only as good as
the information you feed them. And if you don't know to tell it about something,...it can't possibly get the computation right. So, pay your tax pro the $50 - $100.00 to do the computations, if they haven't already.
(The online filing article will be live after Feb. 15th)
Incidentally, if you don't pay the ES payments on time, what happens? Nothing.
No one will come knocking at your door. But, next year, when you file your
return,...there will be penalties to pay.
Who Should Not Make ES Payments?
For some people, the penalties are worth it. They are so good
at managing their money that they earn more than the 10% or so worth of
penalties and interest that accrue by April 15th. For others, they are
paying outrageous rates (15% - 28%) of interest on credit cards and loans.
For you, my friends, it's also cheaper to pay down your cards and loans...The
IRS will charge you less, next April.
__________________________________
Copyright © 1998-2008, Eva Rosenberg
Initially Printed 1998
Reprinted and Revised 2/11/08
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