What Is Estimated Tax?

Estimated tax is a quarterly payment of taxes for the year based on the filer’s reported income for the period. Most of those required to pay taxes quarterly are small business owners, freelancers, and independent contractors. They do not have taxes automatically withheld from their paychecks, as regular employees do.

Estimated taxes may be made for any type of taxable income that is not subject to withholding. This includes earned income, dividend income, rental income, interest income, and capital gains.

The Internal Revenue Service (IRS) requires quarterly estimated tax payments to be filed by those who have income that is not subject to automatic withholding. The taxpayer then files the usual tax paperwork for the full year and pays the balance due or requests reimbursement for an overpayment.

Key Takeaways

  • The quarterly filing system requires people and businesses to pay an estimate of the amount they will owe in taxes for that period.
  • They also file annual tax returns that determine their exact total taxes due.
  • Quarterly filing is required of those who do not have taxes withheld from their incomes automatically.

Due to Hurricane Ida, some residents and business owners in Louisiana and parts of Mississippi, New York, and New Jersey have been granted extensions on their deadlines for filings and payments to the IRS. Most relate to upcoming due dates for quarterly filings and payments. For details, go to the IRS's "Tax Relief in Disaster Situations" page and click on "2021."

Understanding Estimated Tax

Everyone is required to pay the federal government taxes as they earn or as they receive income during the year. In other words, income taxes are pay-as-you-go.

Those who are employed have taxes withheld from their paychecks by their employers based on the W-4 forms the employees complete. Others need to make these payments directly to the government in the form of an estimated tax, rather than waiting until the end of the year to pay when they file their annual tax return.

People who are self-employed, independent contractors, investors who receive dividend income and generate capital gains, bondholders who get interest income, writers who earn royalties on their work, and landlords with rental income are all examples of taxpayers who must estimate the amount of taxes they owe to the government and pay that amount.

Other examples of income liable for estimated tax include taxable unemployment compensation, retirement benefits, and any taxable portion of Social Security benefits received.

Estimated taxes are usually paid on a quarterly basis. The first quarter is the three calendar months (Jan. 1 to March 31). The second "quarter" is only two months long (April 1 to May 31). The third is the next three months (June 1 to Aug. 31), and the fourth covers the final four months of the year.

These installment payments are generally due on April 15, June 15, and Sept. 15 of the current year and on Jan. 15 of the following year.

Installments for estimated tax payments are due on April 15, June 15, and Sept. 15 of the same year and Jan. 15 of the following year.

If the estimated taxes that are paid do not equal at least 90% of the taxpayer’s actual tax liability (or 100% or 110% of the taxpayer’s prior-year liability, depending on the level of adjusted gross income), interest and penalties are assessed against the delinquent amount.

No tax is payable if an individual filer’s net earnings are less than $400. If their net earnings are above $400, an estimated tax must be paid on the entire amount. Individuals must still file a tax return even if they earned less than $400, as long as they meet certain eligibility requirements.

Estimated Tax for Business Owners

Individuals, including sole proprietors, partners, and shareholders of S corporations, must make estimated tax payments on business ownership earnings if the total tax on built-in gains, excess net passive income tax, and investment credit recapture tax is $1,000 or more.

Corporations must pay estimated tax if the business is expected to have at least $500 in tax liability.

In addition, employees who had too little tax withheld and thus owed taxes to the government at the end of the previous year are responsible for making estimated tax payments.

A business owner who reports income on Schedule C and, at the same time, works for an employer who has withheld tax may be able to increase the employer’s withholding so that it equals the person's tax liability for the entire year. In this case, the person will not need to pay estimated taxes on the side business.

IRS Form 1040-ES is used to calculate and pay estimated taxes for a given tax year. A taxpayer who had no tax liability for the prior year, was a U.S. citizen or resident for the whole year, and had the prior tax year cover a 12-month period, does not have to file Form 1040-ES.