How to Calculate:
As underpayment penalties apply, you will likely want to consult a tax professional to help calculate your estimated tax liability. Consistent with the IRS philosophy, accuracy is rewarded and mistakes are penalized. The calculation will be either based on your prior year tax or an estimate on your current year tax. If your current year tax is projected to be less, then you will be overpaying your tax if based on the prior year. If your current year tax is projected to be higher, then you will owe a balance due if going off prior year numbers. It is recommended to be as accurate as possible to assist in budgeting and avoid surprises come April.
When estimating your self-employment income, it is important to estimate your net income factoring in your estimated expenses. Expense estimates for travel, advertising, home office, auto, professional fees and all other ordinary business expenses should be considered. You should also include deductions for self-employment tax, health insurance and the qualified business income deduction. Aside from business income, you should consider your itemized deductions and any credits to which you may be entitled. If you own a business and are taking wages, you will owe estimated taxes on your distribution.
How to Avoid Penalty:
Estimated tax payments must be made quarterly on April 15th, June 15th, September 15th and January 15th. To avoid penalty, you must have paid in (through withholding, quarterly payments, and credits) 90 percent of the tax shown on your Form 1040 or 100% of the amount of tax shown on your prior year return. If you make over $150,000, then the threshold increases to 110% of your prior year tax. If you owe less than $1,000 with Form 1040, you will not be subject to penalty. The easiest way to make your estimated tax payment is via IRS direct pay online or mail in a check with 1040ES Voucher. Estimated taxes are also required for states and the District of Columbia, calculated in a similar fashion, though payments are much less as state tax rates are lower as there is no state self-employment tax.
If you miss a payment or pay less than what was required, you may be charged an underpayment penalty from the date the amount was due. In most cases, you do not need to calculate the penalty; the IRS will calculate the penalty and send you a bill after you file. You may be able to lower or eliminate your penalty by filing IRS Form 2210. If you do not receive your income evenly through out the year, your required estimated tax payments will not be the same for each quarter. For example, if you started operating in the 3rd quarter or earned a bonus in the 4th quarter, you can use the annualized method to calculate your reduced penalty. You may also request a waiver of the estimated tax penalty on Form 2210 if you are retired or have reasonable cause for failing to properly calculate your estimated income on a quarterly basis.