The U.S tax system is a "pay as you go" tax system. Generally, you’re required to make tax payments as you earn income. If you don’t make any estimated tax payments during the year and the amount that you have withheld from your other income is less than 90% of your total tax bill, you run the risk of creating an underpayment penalty for yourself. To avoid an underpayment penalty, you generally should make estimated tax payments if you have self-employment income or other income for which there is no tax withholding.
Example: You’re single and you earn $20,000 a year from a part-time business that you have. You also work for an employer part-time, and earn $30,000 a year. Last year, you worked for your employer full-time and earned $50,000, and you had $7,000 withheld from your paycheck. It was the right amount for you, and you even received a refund. This year, though, you only had $3,000 withheld from your paycheck. You planned on paying whatever you owed when you filed your tax return. This isn’t a wise move, however. You could incur an underpayment penalty of more than $200. You can avoid paying a penalty, though, by making estimated tax payments.
Here’s how it works: When you file your tax return, a certain amount of tax is calculated. For 2010, if your gross income is $50,000 (as in the above example) and you file a single return, you’ll owe about $9,200 in taxes (including self-employment tax on your $20,000 business income). If you paid only $3,000 during the year, then there’s a $6,200 shortfall. The IRS uses a formula to calculate how much tax you should have paid in each quarter, and then applies a percentage (the penalty rate) to figure the penalty amount for each quarter. Then, the penalty amount for each quarter is added together to come up with the total amount of underpayment penalty that you owe.
Sometimes, it’s OK to pay a lot on April 15. The IRS won’t assess a penalty if any of the following situations apply (Estimated tax payments are not the same as withholding for these exceptions.):
The total of you withholding and timely estimated tax payments was at least as much as your prior year tax.
You had no tax liability last year and you were a U.S. citizen or resident alien for the whole year.
You owed some tax last year and you had at least that amount of tax withheld from your paychecks this year. However, if your adjusted gross income is more than $150,000 ($75,000 if you and your spouse filed separate returns in the prior year), you must pay at least 110% of last year’s tax.
You had at least 90% of this year’s tax withheld from your paychecks.
The amount you owe this year is greater than your withholding by not more than $1,000.
You did not have any withholding taxes and your current year (2010) tax is less than $1,000.
Even though the exceptions above may not apply to your tax situation, you still might be able to reduce the amount of penalty that you owe, or avoid the penalty altogether. To do this, though, you’ll have to file a special form -- Form 2210. The H&R Block software will handle this for you in the Underpayment Penalty topic in the interview.
If any of the following situations apply to you, you might be able to reduce or avoid the penalty by filing Form 2210:
Your estimated (quarterly) payments were adequate and timely for your tax situation. For example, you owed $20,000 in tax and you paid $5,000 every quarter.
A large part of your income was generated later in the year. For example, you sold an investment in December and generated a gain.
A large part of your tax payments occurred earlier in the year. For example, you applied a large overpayment from last year’s tax return to this year’s taxes.
Your filing status changed to or from married filing jointly. When you get married (assuming both of you were single in the prior year), you can generally just take last year’s tax on your return and add it to last year’s tax on your spouse’s return. If you filed a joint return last year and your 2010 filing status is not married filing jointly, please refer to Publication 505: Tax Withholding and Estimated Tax, or Form 2210 instructions.
You are a farmer or fisherman and your withholding plus estimated tax payments made by the due date is at least 66 and 2/3 of your current year (2010) tax.
A casualty or disaster occurred, making it unfair for the IRS to impose the penalty. You need to attach a statement to your return to explain this one.
You’re retired or disabled and your underpayment was due to a "reasonable cause rather than willful neglect." You also need to attach a statement to your return explaining what caused the underpayment.
Now, getting back to our example, let’s say that you figured out the flaw in your plan in late September, when $2,600 had been withheld from your paycheck. You see that you need to pay another $6,600. You can avoid a penalty by having this amount withheld by year end. This means that you’ll need to have $2,200 withheld each month for the rest of the year, which will bring your paycheck almost to zero for those three months. You can achieve this by filing a new W-4 form with your employer. Go to the Plan tab in the H&R Block software interview to fill out this form. You can also find a Withholding Calculator on www.hrblock.com. Either way, you’ll know the right amount to put in boxes 5 and 6 of the W-4 form.
In this instance of underwithholding of taxes from an employer, if the full amount of taxes that will be due at the end of 2010 is withheld by the end of the year, you will not be penalized.
You won’t get the same result by making an estimated payment. If you make an estimated payment late in the year, the date matters when calculating the penalty.
Estimated payments, also known as quarterly payments, are the way that you pay tax if you don’t have taxes withheld, or if the taxes withheld from your paycheck aren’t adequate for all of the income that you have. This might be because you’re self-employed, run a small business, have significant investment income, or you’re retired.
Estimated tax payments for 2011 are due April 15, 2011, June 15, 2011, September 15, 2011, and January 15, 2012. When mailing a check, make sure to send Form 1040-ES along with it. For more information, see Estimated Tax (Form 1040-ES).
Suppose you didn't catch your mistake and you truly underpaid your tax, and that's all there is to it. You can have the IRS figure your penalty which means that you don’t need to file Form 2210. This may be the best and most expedient choice for you. Generally, it won't cost you any more to have the IRS calculate the penalty as long as you pay the amount due by the date specified on the bill they send you. In certain cases, you may be required to file Form 2210.