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Avoiding Estimated Tax Underpayment Penalties

Mary writes in to ask:

“Toward the end of last year, I started doing some freelance work in addition to my full time job in order to make ends meet. This year, my freelance earnings have really taken off.

Unfortunately, I just learned that I’m supposed to be making estimated tax payments because of my freelance work, and I haven’t yet made any such payments. If I just make my third quarter estimated payment large enough to cover quarters 1-3, will I be OK? Or will I owe a penalty?”

You will not owe any penalty for underpayment if the amount you owe at tax time is less than $1,000 or if, throughout the course of the year, you make timely payment of at least:

  1. 90% of your tax for this year, or
  2. 100% of your tax from last year (110% for high income taxpayers), which can be found on Line 44 from last year’s Form 1040.

For most people who work as employees, their withholdings are enough to meet one or both of those requirements. So there’s no need to worry about estimated taxes.

Similarly, it’s likely that the withholdings from Mary’s full time job will be enough to cover 100% of her tax from last year, so she probably doesn’t have to worry about underpayment penalties. Still, she should make a point to stow away some cash to pay her (larger) tax bill this year when tax season rolls around.

What if Withholdings Aren’t Enough?

If Mary’s withholdings aren’t sufficient to cover either of the two safe-harbor amounts above (and the amount she’ll owe at tax time is more than $1,000), she has two choices:

If Mary chooses to go the estimated tax payment route, it’s important to note that she’s already missed the first two estimated tax payment deadlines (April 15 and June 15). So rather than wait for the next deadline to roll around and make a triple-sized payment, she should probably go ahead and make a payment now (assuming she has the cash available) in order to stop the ticking clock on her underpayment penalty.

A better approach, however, is to increase the withholdings from her regular job. The reason this approach may be better is that payroll withholdings are treated as if they occurred evenly throughout the year–even if they didn’t. As long as the total necessary amount is withheld over the course of the entire year, there will be no penalty for underpayment, even if much more than 50% of the withholding was done in the second half of the year.

To increase her withholdings, Mary should speak with her employer’s payroll department and request a new Form W-4. When filling out the form, reducing the amount of allowances she claims will increase the amount of money that will be withheld from each paycheck.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
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  1. I was slammed with fees this year come tax time. I work as an independent contractor and had no idea i was supposed to pay quarterly! Thanks a lot uncle Sam!

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