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What are estimated tax payments?
Estimated tax payments are made each quarter to the Internal Revenue Service (IRS) by people whose income isn’t subject to withholding taxes. When people earn income, whether through wages, interest and dividends, or rent, they have to pay taxes on it. Regular employees automatically have their taxes withheld from their paychecks and submitted to the IRS by their employer, but self-employed people and business owners have to estimate how much tax they owe and pay it themselves.
The IRS estimates someone’s tax liability for the year by looking at what she owed last year. According to the IRS’s tax code, an individual has to make estimated tax payments if she’s self-employed and expects to incur a $1,000 tax liability for that year, or if her earnings stem from ownership of a corporation or a partnership in one and expects her tax liability to exceed $500. Both individuals and corporations have to make regular estimated tax payments on all taxable income they earn, and the IRS may assesses a penalty on those who underpay.
Regular employees usually complete a W-4 tax form upon being hired to tell their employer how much to withhold from their wages for tax purposes. The withholding amount is automatically deducted from each paycheck and periodically paid by the employer to the IRS as an estimated tax payment. When the employee files a tax return, she’ll learn whether the amount withheld was enough to satisfy her actual tax burden or whether it was too much and she’s entitled to a refund.
The same is true for self-employed people or people from whose wages taxes are not regularly withheld, such as landlords whose income is in rent payments or independent contractors. Every quarter, they’ll make an estimation from the previous year’s income and submit payments based on that estimate to the IRS as a percentage of earnings that quarter. As with salaried employees, their yearly tax return will reveal whether the estimated payments were too high or too low.
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Estimated tax payments example
Nicolas is a freelance reporter. His employment status is independent contractor, so the newspapers he writes for don’t withhold taxes from his pay. Because he made about $30,000 last year, he estimates that he’ll make about $35,000 this year, meaning that he expects his tax burden to exceed the $1,000 threshold that requires him to make estimated tax payments. Each quarter, he pays a percentage of his income to the IRS based on his understanding of the marginal tax rate he falls into. When he files his yearly tax return, he finds that he overpaid a little, and the IRS sends him a refund for the overpaid amount.