Most taxpayers dread April 15 but take comfort in the knowledge that it occurs only once a year.
That's not the case, though, for millions of people who are required to pay estimated taxes. Sadly, these folks face a tax-filing deadline every April, June, September and January.
If you expect to earn self-employment income this year, or plan to cash in some of your investments, you should familiarize yourself with the rules governing estimated taxes. Otherwise, you could find yourself paying a penalty next April, even if you've sent the IRS a check for the amount you owe.
Here's why: The federal tax system works on a pay-as-you-go basis. You're expected to pay taxes on most of your income all year round.
That's usually not a problem if roughly the amount of tax you owe is regularly withheld from your paycheck. But if your withholding falls short by a significant amount, the IRS will charge you a penalty for underpayment. The IRS may also require you to file estimated tax returns for the next year.
Self-employed taxpayers are accustomed to paying estimated taxes. But even if you work for an employer that withholds taxes from your paycheck, you might not be off the hook. Factors that could trigger an underpayment problem:
•In addition to your regular job, you earn income from freelance or contract work.
•You sell stocks, bonds or other property for a sizable profit and have no losses to offset those gains.
•You lose large deductions or credits. Suppose, for example, you sell your home and move into an apartment. The subsequent loss of your mortgage-interest deduction could trigger a much higher tax bill. Unless you adjust your withholding, you could end up underpaying your taxes.
Fortunately, the tax code gives you some room to maneuver. In general, if you owe less than $1,000 when you file your taxes, the IRS won't hit you with underpayment penalties, says Mildred Carter, senior tax analyst for CCH, a publisher of tax reference books and software. And if your withholding and credits equal 90% of your tax bill, you won't be penalized, either.
The IRS also provides some wiggle room for taxpayers who receive a one-time windfall. As long as your withholding and credits equal at least 100% of the previous year's tax bill (or 110%, if the previous year's adjusted gross income exceeded $150,000), you don't have to pay estimated tax, even if your income jumped sharply.
Here's an example: Say you had your taxes withheld in 2007 and received a small refund. In June, you appear on Antiques Roadshow and learn that your velvet Elvis painting is a rare example of the Velvis genre, worth $100,000. If you sell your painting, you'll have to pay taxes on your profit when you file your 2008 tax return next year. But you won't have to pay estimated taxes as long as your tax payments through withholding and credits for 2008 total at least 100% of your 2007 tax bill (or 110% if your 2007 AGI topped $150,000).
Two other strategies you can use to avoid paying estimated taxes, or at least reduce the amount you'll owe:
•Increase your withholding. This is the easiest way to avoid paying estimated taxes. Calculators on the Internet can help you estimate your withholding. The IRS offers one at www.irs.gov.