Since forming my business last year, the issue of paying estimated taxes has come up throughout the year.
In 2011, it wasn’t necessary because my online income was minimal, but for 2012, the question is coming up again, and my decision is a good case study for those of you wondering whether you need to pay estimated taxes.
As is always the case with tax issues, this is only my experience, and you should consult a qualified tax professional before making decisions for yourself.
The Two-Part Test
I looked at my own tax question through the lens of two different requirements:
- Will I be penalized if I don’t pay estimated taxes this year?
- Would it be beneficial for me to pay estimated taxes this year?
Let’s look at each level in a bit more detail.
Requirements & Penalties
The IRS is pretty clear on what would cause me to be penalized if I didn’t pay estimated taxes throughout the year.
Form 1040-ES (PDF) spells out most of the requirements for individuals. The basic rule that I choose to follow is to pay at least the same amount in taxes that I owed in the previous year. I can do this throughout the year just by maintaining the same paycheck withdrawals I have now, or increasing them slightly if I need to.
Normally, the IRS would penalize you if you owe anything more than $1,000 at the end of the year, but I know that if I follow the simple rule above, I would be OK.
The practice I described gets me off the hook in terms of any potential penalties, but facing a huge tax bill at the end of the year isn’t really my ideal strategy either, even though it’s a free loan from the government.
I went through the following simple exercise to see if paying taxes throughout the year would be worthwhile:
- I used the IRS tax calculator to see how much I would owe or get back based on my paychecks and projected business income and standard deductions that I take every year.
- I added the appropriate percentages for self-employment taxes based on my projected business income.
- I combined the two numbers to total what I expect to owe at the end of the year above and beyond my paycheck withholding.
- Now I can either split that amount into 4 equal payments and pay it as estimated taxes, pay a lesser amount and owe a bit at the end of the year if my business projections are accurate, or not pay estimated taxes at all and put away the money to pay in April.
What Will I Do?
The first estimated tax payments aren’t due until April, so I still have some time to make a decision about what to do and to monitor my business income against my original projections.
It’s likely that I will pay something to at least offset my eventual tax liability for the year.