Who Must Pay Estimated Taxes
If you expect to owe $1,000 or more in tax after subtracting withholding and credits, you must make estimated tax payments. This primarily affects self-employed people, freelancers, investors with significant capital gains, retirees with pension income that does not have adequate withholding, and anyone with substantial income not subject to withholding.
The Safe Harbor Rules
You can avoid the estimated tax penalty entirely by meeting one of two safe harbor rules. Pay at least 90 percent of your current year tax liability through withholding and estimated payments. Or pay at least 100 percent of your prior year tax liability, or 110 percent if your adjusted gross income exceeded $150,000. The prior year safe harbor is the easier one to use because you know exactly what last year's tax was.
How the Penalty Is Calculated
The estimated tax penalty is essentially interest on the underpayment for each quarter. The IRS calculates it separately for each quarterly period. You can underpay in the first quarter and overpay in the fourth quarter and still owe a penalty for the first quarter underpayment.
Waiver Options
The IRS can waive the estimated tax penalty in certain circumstances. If you retired or became disabled during the tax year, the penalty may be waived for one or two quarters. If the underpayment was due to a casualty, disaster, or other unusual circumstance, the IRS may waive it. And if you underpaid due to reasonable cause and not willful neglect, there may be relief available.
A tax attorney evaluates whether the penalty can be waived or reduced based on your specific circumstances. For self-employed clients, we also set up a quarterly payment system to prevent the penalty from recurring in future years.