What Happens If You Overpay Estimated Taxes?
Are you a self-employed who has never dealt with estimated taxes? Is this your first time doing business as a freelancer? If so, you need to get yourself familiarized with calculating and paying estimated taxes during the year so you don’t end up paying penalties in the following year when you file your taxes for the prior year. Overpayment of quarterly taxes results in a tax refund. Underpayment triggers a penalty. Here is the low-down on everything you need to know about making your estimated quarterly taxes.
What are estimated taxes?
The United States income tax system is a pay-as-you-go tax system, which means that you must pay income tax as you earn or receive your income during the year. In other words, taxpayers are required to pay taxes on their estimated annual incomes in four payments spread out over each year. These are called estimated taxes.
Business owners or independent contractors who do not have federal tax withheld from their wages are required to make estimated tax payments.
These payments are for both self-employment taxes and income taxes. You can make payments either through withholding or by making estimated tax payments. If you didn't pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Taxpayers should make estimated tax payments in four equal amounts to avoid a penalty. However, if you receive income unevenly during the year, you may be able to vary the amounts of the payments to avoid or lower the penalty by using the annualized installment method. More on that later.
Employee vs self-employed
If you’re an employee who receives a W-2 from your employer at the end of the year, you don’t really have to worry about paying estimated taxes to the Internal Revenue Service and your state as long as you complete a form W-4 correctly. Your employer will withhold the requested amount of tax and submit that tax to the IRS on behalf of you throughout the year. If you’re a self-employed or a freelancer who receive a Form 1099 or are paid directly from your clients or customers, then you may need to make estimated tax payments on a quarterly basis, rather than wait till you file your annual income tax return to avoid an IRS penalty.
How much am I supposed to pay?
If you’re not sure how much money you’ll earn during the current year, the easiest and safest way to calculate your estimated taxes is to pay 100% of the total taxes you paid last year. You should pay 110% if you’re a higher-income taxpayer.
Generally speaking, if you expect to owe $1,000 or more in taxes for the year after subtracting their withholding and refundable credits, you need to make estimated tax payments. This rule applies to individuals including sole proprietors, partners, and S corporation shareholders. Corporations generally have to make estimated tax payments if they expect to owe tax of $500 or more when their return is filed.
It can be difficult to project your taxes at the beginning of the year. Especially when you’re a start-up, how do you know much to pay? You may have no idea how much you’ll earn for the current year and how much tax you’ll end up paying. As such, the IRS provides the following safe harbor rules that can help individuals avoid penalties for inaccuracy:
Current year safe harbor: if the estimated taxes you pay are at least 90 % of your final bill for 2020 and you made payments on time, no penalties will apply.
Prior year safe harbor: If you use your 2019 tax bill as a barometer for your 2020 liability, you are likewise sure to be penalty-free as long as the taxes you pay are at least 100% of your 2019 bill. However, if your adjusted gross income for 2019 was more than $150,000 ($75,000 for those who are married filing separately), the 2020 payments must be at least 110% of the 2019 bill. It should be noted that different rules apply to farmers and fishermen.
It's best to get as close as possible to the correct amount so you do not have to owe taxes in the next year. As long as you pay 100% of the taxes owed in the previous year, you won't owe any taxes.
On the other hand, if you’re certain your net income will be less this year than last year, you may pay less estimated tax. Base your tax on your taxable income for the current year instead of basing it on last year’s tax.
What if I didn’t pay any taxes last year?
If you paid no taxes last year, you don’t have to pay any estimated tax this year. This applies no matter your income for the year. This only applies if you’re a U.S. citizen or resident for the prior year. Also, your tax return for that year must have covered the whole 12 months.
Quarterly tax payments due dates
When do you have to pay estimated taxes? You normally pay estimated taxes in four installments – typically due on April 15, June 15, and September 15of the current year and then January 15 of the following year. Yet, you don’t have to start making payments until you actually earn income. It means you can skip the first payment if you don’t receive any income by March 31. In this event, you’d ordinarily make three payments for the year starting on June 15. If you don’t receive any income by May 31, you can skip the June 15 payment as well.
If a tax due date falls on a legal holiday or weekend, the deadline gets pushed back to the next business day for your quarterly payment.
How do I pay estimated taxes?
The IRS wants to make it easy for you to send in your money, so the mechanics of paying estimated taxes are quite simple. You have several choices of how to pay:
- With a check sent through postal mail using IRS Form 1040-ES
- By electronic withdrawal from your bank account using IRS Direct Pay
- By credit or debit card—see the IRS website
The annualized income installment method
Another way to calculate your estimated taxes is to use the annualized income installment method. It requires that you separately calculate your tax liability at four points during the year. In here, you must prorate your deductions for these periods. You base your estimated tax payments on your actual tax liability for each quarter, instead of the entire year. This method is often the best choice for people who receive income very unevenly throughout the year. You can pay little or no estimated tax for the quarters where you earn little or no income using this method. If you use this method, you must file IRS Form 2210 with your tax return. This form shows your calculations. Calculating your payments using the annualized income method could be quite complicated so please consult with a tax professional.
If you overpaid your estimated taxes this year, do not worry – as this means you won’t owe any penalty to the IRS and you will be eligible to claim a tax refund for the amount you overpaid. You also don’t want to pay too much that you let the IRS hold your money at zero percent interest. If you estimate your quarterly tax liability very carefully, you won’t need to pay too much taxes or get too much refund when you file your taxes in the following year. If you are having issues or doubts with your tax preparation or Federal Income Tax, contact a CPA or tax professional for advice.
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At Keeper Tax, we’re on a mission to help freelancers overcome the complexity of their taxes. That sometimes leads us to generalize tax advice. Please email firstname.lastname@example.org if you have questions.