Around this time of the year, many people throughout the US are getting notices from the IRS asking them to pay estimated tax penalty. Many people do not understand why they have to pay estimated tax penalty if they have paid all the taxes owed.
Taxes are due when income is earned so even if a person pays all the taxes owed for the prior year by April when the person files a return, the person may still have to pay a penalty when the person did not pay enough estimated taxes by the deadlines for such taxes.
Estimated tax is the method used to pay tax on income that is not subject to withholding such as income from an employer. This includes income from self-employment when someone is an independent contractor, interest, dividends, alimony, rent, gains from asset sales, or prizes and awards.
Estimated tax is due 4 times a year. The IRS imposes estimated tax penalty on the amount of tax underpaid from the date the installment was due to the date the installment was paid. The installment that needs to be paid each quarter depends on the person’s income for the prior year, unless the person completes a form explaining that income is not the same each quarter or each year.
For someone who has a mix of employer income and self-employment or independent contractor income, the taxes from the employer income may be used to offset the amount that is due for estimated taxes on the non-employer income.
A person does not have to pay estimated tax for the current year if the person meets all three of these conditions:
- Had no tax liability for the prior year
- Were a US citizen or resident for the whole year
- Prior tax year covered a 12 month period
- Failure to make estimated payments was caused by a casualty, disaster, or other unusual circumstance and it would be inequitable to impose the penalty, or
- A person retired, after reaching age 62, or became disabled during the tax year for which estimated payments were required or in the preceding tax year, and the underpayment was due to reasonable cause and not willful neglect.