Tax planning and compliance for investors
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Determining how much estimated tax to pay.
In many cases, the best way to determine the amount of estimated tax to pay is the easiest: use the prior year safe harbor. But sometimes this approach means overpaying. The best choice then may be to work out an estimate of the current year's tax liability.
The same "prior year safe harbor" you use to determine whether you have to pay estimated tax (see Who Must Pay) can be used to determine how much you have to pay.
Example: Your total tax for 2008 was $37,000. Your withholding and credits for 2009 will be $21,000, so you can't rely on the prior year safe harbor to avoid paying estimated tax. But you can use the prior year safe harbor to determine how much to pay: $16,000, or $4,000 per quarter.
The majority of people who pay estimated tax rely on the prior year safe harbor. It has some major advantages over actually estimating the current year's tax:
Some people wonder whether they're permitted to use the prior year safe harbor even if they know they're going to owe more tax for the current year. The answer is yes. If you qualify, the prior year safe harbor is a safe way to avoid the penalty for underpayment or estimated tax, no matter how large the underpayment is or how obvious it was that you would end up having an underpayment.
The prior year safe harbor requires a payment of 110% of the prior year's tax (not just 100% of the prior year's tax) if your adjusted gross income for the prior year was over $150,000 ($75,000 if you are married and filed separately).
There are two situations where you may choose not to use the prior year safe harbor.
If you have good reason to believe that 90% of your current year's tax will be significantly lower than your prior year's tax, you'll pay a lot more than necessary if you rely on the prior year safe harbor.
Example: Last year you had unusually high income because you exercised nonqualified stock options. You expect your income to be $80,000 lower this year. If you use the prior year safe harbor for this year, you'll pay $30,000 more than necessary, so it makes sense to base your payments on 90% of the current year estimated tax.
You shouldn't worry too much about the possibility that the current year tax will be slightly smaller. All that means is that you'll get a small refund when you file your tax return. But you wouldn't want to overpay by $30,000 because you'll lose the opportunity to earn interest on that amount while you're waiting for your refund.
There's nothing necessarily wrong with using the prior year safe harbor when the current year tax will be higher. As discussed above, you can use this rule even if you're dead certain that your current year's tax will be a lot higher than the prior year's tax.
But some people aren't comfortable with the notion that they'll owe a huge tax bill in April. And if anything happens to the money before April 15, and you're not able to make the payment then, you're in a world of hurt. Some people choose to make Voluntary Payments so they know they won't get into that situation.
Form 1040-ES (the form used to pay estimated tax) comes with a worksheet you can use to estimate how much tax you'll owe for the current year. There's certainly nothing wrong with using this worksheet — but most people don't. The reason is that the worksheet takes you through more detail than may be necessary, but still leaves you with nothing better than an educated guess about your tax liability. The usual way to estimate taxes is a somewhat simplified method:
Many people using this method don't bother looking up changes in tax rates, standard deduction and personal exemptions that result from inflation adjustments. These changes will decrease your tax slightly, so that's one way of providing a cushion of extra payments.
Example: Suppose you estimated your current year's taxable income exactly right, but used the tax rate schedules for last year to estimate the tax. You would get a refund, because the inflation adjustments for the current year result in a lower tax.
If you want to use the current numbers, they are available in our Reference Room.
In some cases it makes sense to take into account changes in the law other than inflation adjustments that can make a significant difference in your tax liability. Tax changes for each year are highlighted in IRS Publication 553.
Once you've determined how much you need to pay, you should consider whether to use estimated tax payments or an increase in withholding to cover this amount. Before we turn to that question, we'll look at the possibility of making voluntary payments in excess of the minimum amount required.
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