What Is Annualized Income?
Annualized income is an estimate of the amount?of money that an individual, a business, or an investment generates over a year's time. It is calculated based on less than one year's worth of data, so it is only an approximation of total income for the year.
- Annualizing income is useful for anyone whose income varies dramatically through the year, or anyone who has several sources of income that are paid on different schedules.
- To annualize income based on less than one year of data, multiply?total earned income by the ratio of the number of months in a year divided by the number of months for which income data is available.
- This gives you a realistic number for monthly budgeting or estimated taxes due.
Understanding Annualized Income
Annualized income can be calculated by multiplying the earned income figure by the ratio of the number of months in a year divided by the number of months for which income data is available.
Say, for example, a consultant earned $10,000 in January, $12,000 in February, $9,000 in March, and $13,000 in April. The earned income figure for those four months totals $44,000. To annualize the consultant's income, multiply $44,000 by 12/4 to equal $132,000.
How Estimated Tax Payments Work
Taxpayers who have jobs pay an estimate of their annual taxes through employer tax withholdings. Business owners make estimated tax payments each quarter.
There are many other sources of income that are not subject to tax withholding. Income from self-employment, interest and dividend income, and capital gains income are not subject to tax withholdings, nor are alimony and some other sources of income that may be reported to a taxpayer on Form 1099.
To avoid a penalty for tax underpayment, the total tax withholdings and estimated tax payments must equal the lesser of 90% of the tax owed for the current year or the full tax owed in the previous year.
Examples of Annualized Income That Fluctuates
Computing estimated tax payments is difficult?if the taxpayer’s income fluctuates during the year. Many self-employed people generate income that varies greatly from one month to the next.
Assume, for example, that a self-employed salesperson earns $25,000 during the first quarter and $50,000 in the second quarter of the year. The higher income in the second quarter indicates a higher total level of income for the year, and the first quarter’s estimated tax payment is based on a lower level of income. As a result, the salesperson may be assessed an underpayment penalty for the first quarter.
Avoid Underpayment Penalties
To avoid underpayment penalties due to fluctuating income, IRS Form 2210 allows the taxpayer to annualize income for a particular quarter and compute the estimated tax payments based on that amount.
Schedule AI of Form 2210 provides a column for each quarterly period, and the taxpayer annualizes the income for that period and computes an estimated tax payment based on that?estimate.
Using the salesperson example, Form 2210 allows the taxpayer to annualize the $25,000 first-quarter income separately from the $50,000 second-quarter income.
What Is the Formula for Annualized Income?
The formula is simple if you have 12 months of data: Add up the monthly income received during a period of 12 months. Divide by 12. There's your annualized income.
If you have less than 12 months of data, multiply the earned income figure by the ratio of the number of months in a year divided by the number of months for which the data is available. That should yield a reasonable estimate.
Why Would I Want to Annualize My Income?
If your income varies drastically throughout the year, calculating your annualized income helps you budget sensibly. If, for example, you grow Christmas trees for a living, most or all of your income will come at the end of the year but you have to cover your monthly expenses for the entire 12 months. Annualizing gives you a good estimate of how much you'll have to spend.
Similiarly, some people have side gigs or seasonal income sources that add substantially to their incomes. Calculating annualized income tells them how much extra income they'll have year round.
Should I Annualize Income for My Business?
If you're running your own business, you're paying your estimated taxes due on a quarterly basis. Many businesses experience big swings in revenue seasonally. Calculating your business' annualized revenue allows you to budget properly for the entire year. It also helps you estimate the taxes you owe accurately.
The Bottom Line
Annualized income is a useful calculation for anyone whose income varies greatly from month to month or whose income comes from a variety of sources that are paid on different schedules.
If you're one of those people, annualization can help you budget your money from month to month. It also can help you accurately estimate the amount of taxes you owe.