Does it Make Sense to Pay Quarterly Estimated Tax Payments?

When people learn I’m a CPA, one of the first things they assume is that I “do taxes.” Often, they have a “quick tax question.” As a tax practitioner, I know a quick tax question is an oxymoron. It’s nice, however, to be able to translate some of our CPA lingo into easily understood information, both for clients and friends. One issue that stands out to me is: when and why does it makes sense to consider making quarterly estimated tax payments? 

Individual estimated tax payments – a primer

The government likes to get their money on a regular schedule. For most people, that means withholding from a paycheck. But if that’s not your situation, the IRS has estimated tax penalties in place that preclude you from waiting until April 15 every year to pay the balance due. In order not to be subject to those penalties, during the year you must pay at least 100 percent (or 110 percent depending on your level of income) of your previous year’s tax liability OR at least 90 percent of your current year’s tax liability. And unless there is a special circumstance where your income fluctuates during the year, those payments are expected to be paid in quarterly installments. 

If income is expected to increase dramatically, a strategy for cash flow conservation is to pay what’s known as the “safe harbor,” which means paying 100/110 percent of the prior year’s liability, and then being ready to pay the remaining balance due on April 15. In cases of fluctuating income and varying cash flow, one approach is to start the year paying the safe harbor estimated payments, and then for the third or fourth installment evaluate whether the amount should be adjusted up or down.

Estimated tax payments to the IRS can be made online, by phone or by mail. Most states also have several options for making payments, so individuals can choose what method works best for their situation.

My common advice is to set aside a flat percent of revenues in a separate account to help make payments when they’re due.

Here are some scenarios you may encounter where making quarterly estimated tax payments should warrant a detailed discussion:

I. “I started my own business this year.”

This situation raises additional questions:

• Is bookkeeping already in place?
• What are the retirement planning goals
• What is the most effective business structure to meet operational, industry licensing, and tax-saving needs?

As the business is getting off the ground, it may be necessary to calculate each quarter what the estimated net profit of the business is to determine the amount of the payments.  

II. “I just started selling LulaRoe/Norwex/Rodan + Fields/(fill in the blank) to make some extra money.”

This scenario is a little trickier and would again depend on the level of net profit the person expects the business to generate. If the individual is doing this work in addition to their regular job, they can also consider adjusting their withholding to account for the additional income and to prevent underpayment penalties. Taking a look each quarter and making an estimated tax payment will help avoid surprises the following April.

III. “I exercised/am going to exercise my stock options.”

This is when you need to see a tax professional immediately! It’s not just your potential tax bill that needs to be evaluated, but also the entire financial situation may have to be taken apart and analyzed in-depth. The main question to ask is why am I exercising? The tax impact may be so substantial that it might as well call for a 2-3 year tax and cash flow projection.

IV. “I inherited an investment account from my mom.”

In this case, the determination would depend on the investment income that the account will generate. Another good opportunity that exists in this scenario is to consider the tax implications of the investments. Most investors focus on achieving the highest possible pre-tax return and leave the tax planning until after investment gains or losses had already been realized. Many studies concluded that tax-aware portfolios produced investment returns two percentage points higher than portfolios that ignored taxes.

V. “My husband and I both work, we have some investment income, and every year we owe a lot with our tax return.”

In this very common situation, the best fix is likely to adjust the withholding for one or both spouses rather than making quarterly estimated taxes. If one of the spouses is already claiming zero allowances, then it’s likely he or she will need to specify an additional amount they want withheld from each paycheck. This is a very simple fix made possible by completing and submitting a new IRS Form W-4 and applicable state form(s) to the company HR specialist.

VI. “I’m retiring this year.”

Determining whether quarterly estimated tax payments are necessary will depend on the sources of the individual’s income. For example, if a large part of his or her income will now be from retirement distributions, then federal and state withholding will likely be the best and easiest answer. However, there are still a lot of moving parts to discuss related to cash flow needs, required minimum distributions, investment income and many other factors.

Whatever is the problem you are facing, my goal will be to determine the real root of the problem and find the most painless approach to attain your financial well-being.

Please schedule a visit with me prior to the end of year to have adequate time for tax planning.

For more guidance on estimated tax payments, see IRS Publication, Tax Withholding and Estimated Tax.