How To Avoid Paying Too Much Estimated Tax
by: Wayne M. Davies
Many self-employed people and small business owners make
quarterly estimated tax payments at both the federal and
state level. (Sigh!)
If you're newly self-employed and perhaps
unfamiliar with the government's estimated tax
payment schedule, here are the due dates for the Year
2006 quarterly estimated tax payments:
QTR 1: April 15, 2006
QTR 2: June 15, 2006
QTR 3: September 15, 2006
QTR 4: January 15, 2007
The form used to accompany the payments is Form 1040-ES.
You can download the form and its instructions here:
http://www.irs.gov/pub/irs-pdf/f1040es_05.pdf
By the way, I have no idea how they came up with these
"quarters" -- the first quarter coincides with the calendar
quarter, but the other three don't. Two of the "quarters"
aren't even three months. Go figure.
Still with me? Good. Let's get down to business.
If your business income fluctuates from year to year, as is
often the case for the small business owner, it can be
difficult (if not impossible) to know exactly what your tax
liability is going to be for the whole year until the year
is over.
So many self-employed people end up being too conservative.
They fear having a balance due on their tax return and pay
way too much estimated tax during the year. They end up just
like the W-2 employee who has too much income tax withheld
from his/her paycheck. The end result -- the self-employed
person also gets a large refund, and has given the IRS an
interest-free loan of his hard-earned money. Not good!
The self-employed person has two options to avoid
overpayment of estimated tax.
OPTION 1:
Do your best to track your income and expense during the
year. If you are running a successful small business, you
should be recording your income and expenses each
month, and you should be able to produce reports that tell
you exactly how your business is doing each month. Either
you are doing this yourself with the help of a software
program or you are paying a bookkeeper or accountant to do
this.
The point: if you don't know what your bottom line is every
month, you are making a big mistake! If you are waiting
until the end of the year to see what the numbers look like,
you are mismanaging your business.
This monthly financial summary is essential
both from a business management/cash flow standpoint, and
also from a tax standpoint. From a tax standpoint, once you
know your profit for a given quarter, you can then calculate
the resulting tax liability on that quarter's profit, and
you can make a reasonably accurate quarterly estimated tax
payment instead of just "winging it" and paying too much (or
too little).
OPTION 2:
Here's another great way to take care of your quarterly
estimated tax payments. Option 2 is what the Tax Code calls
"The Safe Harbor Method," defined as follows:
The Tax Code says that most taxpayers can calculate the
minimum amount of estimated tax by paying the previous
year's tax liability in the current year. Let's say you are
trying to figure out how much estimated tax to pay for Year
2006. Let's also assume your Year 2005 federal income tax
liability was $10,000. For Year 2006, you take the $10,000
and divide it by 4, and you would pay $2,500 per quarter.
Now that wasn't too hard, was it?
As you can see, this is a much easier method to use than
Option 1, because it takes less time to calculate.
There is another advantage to The Safe Harbor Method: if
your income (and resulting tax liability) increases in 2006
compared to 2005, you can still pay the Year 2005 tax
liability amount in Year 2006 and not incur any penalty or
interest for having a balance due on the Year 2006 return.
As long as you pay that Year 2006 balance due by April 15,
2007, it doesn't matter how much you owe on the 2006
return. You have complied with the "safe harbor" rule for
quarterly estimated tax payments.
So Option 2 lets you calculate your estimated tax payment
amount in literally seconds, and it also lets you "get away"
with paying a minimum amount of tax during the year without
any fear of penalty for waiting until April 15 to pay the
rest.
Practically speaking, Option 2 is often best for self-
employed people whose income remains relatively constant
from year to year. If your income dramatically increases
one year, keep in mind that you can still pay the previous
year's tax liability and hang on to your money for a few
extra months, but eventually you will have to come up with
that large balance due. If you like waiting until the last
possible day to pay your balance due, then Option 2 is for
you. Just make sure you "put something aside" to take care
of that large balance due.
Also, please notice that I said that "most" taxpayers can
pay last year's tax liability to qualify for the Safe Harbor
method. If your income is over $150,000, then the amount of
estimated tax you are required to pay is 110% of the
previous year's tax liability, not 100%.
Just another example of an exception to a tax rule.
About The Author:
Wayne M. Davies is author of 3 tax-slashing eBooks for small
business owners and the self-employed. For a free copy of
Wayne's 25-page report, "How To Instantly Double Your
Deductions" visit http://www.YouSaveOnTaxes.com.
March 2006
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