The skinny on paying estimated taxes
Safe harbor refers to a regulation that eliminates a person's liability as long as the party acted in good faith. In the case of income taxes, it's an amount that protects you from IRS penalties for income tax underpayment.
Many taxpayers opt to pay 100 percent of their prior year's tax bill because it gives them a specific number to work with. Even better, it protects them from penalties and interest, regardless of how high their upcoming final tax bill goes.
Navigating safe harbors
Still, the safe harbor payment is a little more costly if you make a lot of money.
If your previous year's adjusted gross income was more than $150,000 for married couples filing jointly and single taxpayers; $75,000 for married taxpayers filing separately, and you want to base your estimated tax payment on the prior year's amount, you'll have a higher safe harbor percentage to meet.
In these cases, the IRS expects the high-earning taxpayer to pay at least 110 percent of his or her previous year's tax bill. That means if your adjusted gross income on that previous return was $150,000 and you ended up with a $30,000 tax bill, the IRS expects you to pay $33,000 -- $30,000 plus 10 percent -- in estimated and withholding taxes to guarantee you don't encounter additional tax penalties.
"With both (partners) in a couple earning or people holding multiple jobs, the salary cap is not as out of reach as it may seem, especially if they had a good investment or sold a piece of investment property during the year," says Durand.
Paying only when you earn
Although the IRS prefers four equal payments of estimated taxes throughout the year, you don't have to pay estimated taxes until you receive untaxed income.
If most of your untaxed income comes in one quarter, such as stock dividends paid at year's end, or if you operate a business in which income fluctuates throughout the year, you might want to consider paying your estimated taxes under the annualized income system.
"The annualized method allows you to take a look at each quarter independently and pay the tax in the quarter that you earned it," says Durand. "Say your job is one where most income is in the summer, such as landscaping, rather than the winter. You want to pay the taxes when you have the money."
With this approach, your required estimated tax payment for one or more periods might be less than the amount figured using the four-equal-payments method. To find that out, you'll have to complete a work sheet found in IRS Publication 505, Tax Withholding and Estimated Tax. Sole proprietors need another work sheet found in IRS Publication 505 to determine annualized self-employment taxes that are included with the estimated payments.
And you'll need to file Form 2210 with your annual return to explain why you didn't send in the expected equal payments, Durand says. This will keep the IRS, which assumes you earned the money equally during the year, from charging you an underpayment penalty and interest for not paying enough in a particular filing quarter.
"It is a little more complicated," Durand says. "But for cash flow it's better, and it puts the tax in the quarter when it is earned."
Avoiding estimated taxes altogether
Are you already panicking at the prospect of struggling through work sheets and filing even more tax returns? You might have yet another option.
If you have wage income in addition to untaxed earnings, file a new W-4 at work and ask your boss to start taking out more payroll taxes to cover any shortfall. This strategy also works for couples who file jointly, but only one spouse has wage income subject to withholding.
Your (or your spouse's) take-home pay will be a bit lighter, but you'll be off the hook for estimated tax payments.