If you have income not subject to tax withholding (think passthrough business income, rental income, and investment income), generally, you are required to make quarterly payments to cover the tax. How much to pay and when can be confusing – here is an overview of the process.

What to pay

First, it is important to recognize that you cannot pay your entire tax obligation on the last day of the year without owing interest and penalty. Instead, the IRS requires that you pay tax throughout the year and offers two options for meeting that requirement: 1) basing tax payments on last year’s income tax or 2) basing tax payments this year’s income tax. These options are commonly known as “safe harbors”.

If relying on the prior year safe harbor and your income was more than $150,000 last year, you must pay 110% of your prior year tax obligation evenly throughout the year. For example, if your income tax was $100,000 last year, you would owe $110,000 this year in four quarterly installments of $27,500 each. If your income was less than $150,000 in the prior year, the same calculation applies except that the 110% threshold is replaced by 100%.

The advantage of the prior year safe harbor is that the payments are easy to calculate and predictable. The disadvantage is that your prior year tax obligation may not reflect your current year tax liability, potentially leading to a big overpayment or underpayment when you file.

If you choose the current year safe harbor, 90% of your current year tax obligation must be paid quarterly with the remaining balance due by the April filing deadline. The advantage to this approach is accuracy. Because you will be calculating and paying your tax obligation each quarter, you are unlikely to be surprised with an unexpected tax bill when you file your return. The disadvantage is that it can be costly if you are using a tax pro to calculate your payments each quarter.

When to pay

Adding to the complexity is the IRS quarterly payment deadlines do not fall evenly every three months. What? It’s true, the second quarter covers two months and the fourth quarter covers four. These payment dates are easy to overlook, so we recommend adding them to your calendar:

• Q1 – April 15th
• Q2 – June 15th
• Q3 – September 15th
• Q4 – January 15th

If using the current year safe harbor, your estimated tax payments should cover taxable income recognized through the month prior to the payment deadline. For example, your April 15th payment must cover income earned through March. The prior year safe harbor is easier to manage because the payment amounts are the same each quarter.

Which safe harbor method should you choose?

Generally, we recommend a combination of the two. Unless you know early in the year that your income will be significantly different from the previous year, making the first two payments using the prior year safe harbor will give you more than half the year to estimate how your current year tax liability is shaping up. You can then use the final two payments to meet the 90% threshold, or, if you prefer, pay in full.

What should be the goal for paying estimated tax?

• No penalty or interest assessments
• Plenty of time to budget for and pay the appropriate quarterly amounts
• Either zero balance due or an accurate budget of what is owed by the April deadline

To meet this goal, we recommend a review of income with your tax advisor several times throughout the year. Our cadence is first quarter (March/April), mid-year (June/July), and year-end (December/January). Frequent communication is the key to avoiding tax surprises.

Final considerations

• Federal payments may be made electronically or by paper check. If paying electronically, initiate your payment several days before the deadline. Paper checks must be mailed by the payment deadline and accompanied by a payment voucher.
• Many states follow the federal guidelines for payment dates, safe harbor amounts, and acceptable payment methods, but many do not. Check the state(s) in which you file to ensure that you are following their rules.

While tax withholding may seem complex, a trusted advisor can help to guide you in your financial decisions and tax estimating process. Contact our team today to discuss your situation.