Definition
People who are self-employed or receive substantial income from an employer that is not required to practice payroll withholding (such as lawyers and owners of rental property) are required by the IRS to estimate their tax liability and pay their taxes in advance in quarterly installments.
Why It’s Important
Estimated taxes are a critical component of managing finances for self-employed individuals. By making estimated tax payments quarterly, self-employed individuals can ensure that they do not owe money to the IRS at the end of the year and face potential penalties or interest charges.
When making estimated tax payments, it is essential for self-employed individuals to accurately calculate their estimated tax liability by considering all sources of income and allowable deductions. If an individual underestimates their tax liability, they could be required to pay more taxes than necessary. On the other hand, if an individual overestimates their tax liability, they may receive a refund from the IRS. However, this refund may come with interest if payment is made after the deadline for filing the return.
In addition to avoiding penalties and interest charges, paying estimated taxes helps self-employed individuals plan ahead financially. Making regular payments on time allows them to evenly distribute their financial burden throughout the year instead of needing to make a huge lump sum payment at one time when filing their return. This also makes it easier for them to budget accordingly by factoring in their actual income and estimated quarterly tax payments.
Finally, one of the most essential benefits of paying estimated taxes is that it allows self-employed individuals to avoid being subject to alternative minimum taxes (AMT). The AMT is an additional form of taxation that applies to taxpayers with substantial income but who do not pay enough in taxes during the year through payroll withholding or estimated payments. By ensuring that adequate funds are set aside each quarter for estimated taxes, self-employed individuals can avoid facing the AMT and its potentially significant financial burden.
