Have you made your quarterly tax payment? There's a penalty if you forget.
Tax penalties have surged on estimated-tax payments for millions of Americans.
Taxes can be a conundrum for self-employed workers.
If you don’t have an employer withholding taxes from your paycheck, you must make estimated payments to the IRS in quarterly installments. The most recent deadline was this week.
Figuring out what your tax bill will be for the year is tricky, especially if your income and business expenses fluctuate. But it’s non-negotiable, and kicking it down the road can pack a punch. The penalty you pay for underpayment has soared this year.
“The US tax system is a 'pay-as-you-go-system,' meaning taxpayers are required to pay tax on their income as they receive it,” Kathy Pickering, chief tax officer at H&R Block, told Yahoo Finance. “Individuals who earn income through other means, such as gig contracts or investments, may not realize that they are required to pay tax on that income as they earn it — not just at the end of the year.”
In general, taxpayers may avoid the “Underpayment of Estimated Tax by Individuals Penalty” if they owe less than $1,000 when they file their return or if they paid either 90% of the tax shown on the 2024 tax year return or 100% of the tax shown on the return for the previous year, Pickering said.
Read more: Filing taxes as an independent contractor: A step-by-step guide
Interest due on underpayment of taxes has soared
Should you miss that target, you’ll face an interest charge on the amount of the underpayment. The rate is set and published quarterly by the IRS. Thanks to high interest rates overall, it’s currently 8%, up from 3% two years ago. The rate is a calculation of the federal short-term rate plus three percentage points.
The average estimated tax penalty in fiscal year 2023 jumped to about $500 from about $150 in 2022, according to the most recent IRS Data Book. The number of tax filers who paid the penalty rose to 14 million from 12 million during that same time period. Overall, the agency assessed $7 billion in estimated tax penalties in 2023, nearly quadruple the $1.8 billion it assessed in 2022.
H&R Block, for instance, has seen an uptick in clients facing penalties, Pickering said. One reason for the surge in penalties is that the IRS temporarily suspended the mailing of automated reminders to pay overdue tax bills in 2022 after the pandemic. At the beginning of this year, the IRS resumed its normal collection process for tax bills, including the underpayment of estimated tax penalties.
“It can feel overwhelming to determine how to estimate your taxes, but the government doesn't want to wait for their money,” Russell Garofalo, founder of Brass Taxes, a tax firm that works with freelancers and self-employed people, told Yahoo Finance. “That's what estimated tax payments are all about.”
Read more: Yahoo Finance's tax guide: Everything you'll need to file your taxes on time
How it works
Interest on the amount owed accrues daily. In other words, the interest is assessed on the previous day’s balance. So even if you miss a quarterly payment, making a payment to the IRS at any date can pare back your potential penalty charges.
“Paying estimated tax as soon as you discover you have a shortfall is very helpful,” IRS spokesman Eric Smith told Yahoo Finance. “It helps lessen and may even eliminate the penalty.”
It's a hard concept to explain to people “because of all the nuance to when and how it's applied,” Garofalo said. “Some people care a lot about not paying another $200, or however much, in a penalty, and for others, that $200 is a small price to pay for not thinking about their taxes during the year or not being anxious about being cash poor if jobs dry up and they need that money to live.”
The rules, however, are the rules. Taxes must be paid as you earn or receive income during the year, either through withholding or estimated tax payments. Meanwhile, it's not just self-employed contract workers and freelancers who can get caught in this underpayment trap. If you receive income such as interest, dividends, alimony, capital gains, prizes, and awards, you may have to make estimated tax payments.
If you are retired and have a pension, or are making withdrawals from a traditional IRA or similar retirement plans, or have a Social Security check, you're probably already having the taxes withheld. For more details, see IRS Publication 505.
Read more: 3 ways retirees can save on taxes
Running your numbers
If your income is consistent, you can estimate how much you’ll make and owe in taxes for the year and send a fourth of that to the IRS each quarter.
The other option is to look at your taxes from last year to see how much taxable income you earned and use that as a starting point when estimating your quarterly payments. Based on your previous year’s federal tax return, you (or your accountant) can figure out the total amount you will owe Uncle Sam next April 15 and how much you should pay in quarterly estimated taxes throughout the year.
If your state has an income tax, you are also typically required to make estimated tax payments. Certain cities, such as New York City, also collect income tax as part of your state filing.
The good news is that it’s relatively early in the year. “Taxpayers still have a lot of time to make sure they have enough paid in, either through withholding or estimated tax payments,” Smith said.
Where to get help
I have always balked when it’s quarterly tax time again, having freelanced entirely or periodically throughout my career. I know that dreaded feeling.
My advice: Go to the IRS Self-Employed Individuals Tax Center to help you understand how to pay federal taxes as an independent contractor. Depending on the location of your home office, you may be required to file state and local income and business taxes as well.
You can use Form 1040-ES, which includes a worksheet for you to calculate your estimated tax payments for the year. The worksheet requires you to estimate your adjusted gross income (AGI) and deductions for the year.
To figure out the right amount to set aside, check out the IRS Tax Withholding Estimator, an online calculator. And you can set up an automatic payment for the quarterly due dates directly with the IRS. If you pay your taxes via electronic filing, for instance, you can schedule all four quarterly payments at once and save yourself the headache of potentially forgetting.
If your freelance income is a side gig or you have income from a retirement plan withdrawal, you have another withholding option.
“The real advantage of withholding is that it’s treated as occurring evenly throughout the year,” Smith said. “So if a side gig worker, for example, has a withholding source —a W-2 job or retirement plan payout— they can bulk up the withholding on that to cover the income on which there is no withholding.”
The worst move to make is to ignore it. “Some people make the mistake of, in effect, thinking, 'Well, I missed the estimated tax deadline, so I might as well just wait until the end of the year to pay,'” Smith added. “The answer to that is no.”
Kerry Hannon is a Senior Columnist at Yahoo Finance. She is a career and retirement strategist, and the author of 14 books, including "In Control at 50+: How to Succeed in The New World of Work" and "Never Too Old To Get Rich." Follow her on X @kerryhannon.
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