Legal Definitions - estimated taxes

Estimated taxes are payments made throughout the year to the Internal Revenue Service (IRS) by individuals whose income is not subject to regular tax withholding by an employer. This system ensures that taxpayers pay income tax as they earn or receive income, rather than waiting until the end of the year. It primarily applies to income sources like self-employment earnings, rental income, interest, dividends, and certain other types of income where an employer does not automatically deduct taxes from paychecks.

Taxpayers are generally required to estimate their total tax liability for the year and make these payments in four equal installments throughout the year. Failing to pay enough estimated tax, or missing payment deadlines, can result in penalties, including interest charges and fines. Typically, taxpayers must pay at least 90% of their current year's tax liability or 100% of their previous year's tax liability through withholding and estimated tax payments to avoid penalties.

Here are a few examples to illustrate how estimated taxes work:

• Example 1: Freelance Professional

  Maria is a freelance graphic designer who works with multiple clients throughout the year. Since none of her clients are her employer, they do not withhold income taxes from the payments she receives for her design services. To meet her tax obligations, Maria must estimate her total annual income and expenses from her freelance work. Based on this estimate, she calculates her projected tax liability and makes quarterly estimated tax payments to the IRS. This ensures she pays taxes on her self-employment income as she earns it, avoiding a large tax bill and potential penalties at the end of the tax year.

• Example 2: Rental Property Owner

  David owns a duplex and receives monthly rent payments from his tenants. This rental income is not subject to tax withholding by an employer. David must account for this income, along with any deductible expenses related to the property, to determine his net rental income. He then includes this amount in his overall income estimate for the year and makes quarterly estimated tax payments to cover the income tax liability arising from these earnings. By doing so, David ensures he is paying taxes on his rental profits throughout the year, rather than facing a significant tax payment and potential penalties when he files his annual return.

• Example 3: Significant Investment Income

  Sarah is retired and receives a substantial portion of her annual income from stock dividends and capital gains generated by her investment portfolio. While she might receive a small pension with some tax withholding, the significant and often fluctuating income from her investments is not subject to automatic tax deductions. Sarah needs to project her expected investment income for the year and factor it into her estimated tax calculations. She then makes quarterly estimated tax payments to the IRS to cover the tax due on these investment profits, preventing a large tax bill and potential penalties at the end of the tax year.