How to Calculate and Pay Estimated Taxes
Disclaimer: The content on this blog is for informational purposes only and does not constitute professional financial advice. The information here should not be relied upon without seeking advice from a professional tailored to your individual circumstances. I disclaim any liability for actions taken based on the content of this blog.
Have you heard that you should be paying quarterly estimated taxes but aren't sure how much to pay or how to pay them? You’re not alone. I work with many Shopify sellers who don't fully understand their tax responsibilities. Lucky for you, I am going to break it all down.
After reading this post, you will feel more informed because you'll learn about the importance of estimated taxes and how to calculate and make your payments. This knowledge will allow you to stay compliant and avoid underpayment penalties.
What Are Estimated Taxes
Estimated taxes are periodic payments made to the IRS on income not subject to withholding, such as self-employment income, interest, dividends, alimony, rent, and gains from the sale of assets.
The tax system is a "pay as you earn" system. Usually, as you earn income from an employer, they are responsible for collecting and remitting taxes from your wages on your behalf. However, as business owners, our income is not subject to withholding, so no one withholds and remits taxes for us. That responsibility falls on us.
Paying estimated taxes helps prevent a huge tax bill when you file your yearly taxes. This proactive approach not only helps you manage cash flow but also ensures compliance with IRS regulations. By understanding and meeting your estimated tax obligations, you can avoid the stress of last-minute tax surprises and focus more on growing your business.
Who Needs to Pay Estimated Taxes?
If you expect to owe at least $1,000 in taxes after subtracting withholding and credits, then my friend, you are required to make estimated tax payments. This applies whether you are a freelancer, contractor, or business owner. It includes anyone earning income that isn't subject to withholding, including gig workers, independent consultants, and those with investment income. For instance, if you operate a small business or work as an independent contractor, your income isn’t automatically taxed. Therefore, you need to estimate your taxes and pay them quarterly.
The Components of Estimated Taxes
Before I tell you how to calculate and pay your estimated taxes, it's essential to understand its components. Your estimated tax payment is a combination of three types of taxes: federal income tax, state income tax, and self-employment tax. Accurately estimating each component is crucial to ensure you pay enough to avoid penalties.
Federal Income Tax
Federal income tax is the primary tax imposed by the federal government on the annual earnings of individuals, businesses, and other entities. It is based on your taxable income, which is your total income minus any allowable deductions and exemptions. The tax is calculated using progressive tax rates, meaning that higher income levels are taxed at higher rates. These rates and the corresponding income brackets are updated periodically by the IRS. Federal income tax helps fund various government programs and services, such as national defense, Social Security, healthcare, and infrastructure.
State Income Tax
State income tax is a tax levied by individual states on the income earned within that state. Not all states impose an income tax. Currently, nine states do not have a state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. You can skip this step if you live in one of these states (like I do in Florida – lucky us!). For those that do, the rates and rules can vary significantly from state to state. State income tax is used to fund state-specific programs and services, including education, transportation, public safety, and healthcare. The tax is typically calculated similarly to federal income tax but with state-specific adjustments, rates, and exemptions.
Self-Employment Tax
Self-employment tax consists of Social Security and Medicare taxes for individuals who work for themselves. If your net income is greater than $400, you will be responsible for this tax. If you are self-employed, you are responsible for paying both the employer and employee portions of Social Security and Medicare taxes. This tax is calculated on your net earnings from self-employment, which is your gross income from your business minus your business expenses. The self-employment tax rate is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. Self-employment tax is critical for self-employed individuals to ensure they contribute to and receive benefits from Social Security and Medicare.
How to Calculate Your Estimated Taxes
Now that you know the components of Estimated Taxes, let’s dive into how to calculate your payment. There are two methods you can use. Method 1 involves calculating based on your current year's income, while Method 2 uses your previous year’s tax liability. Method 2 is the easiest of the two, and I highly recommend it if math isn’t your strong suit. However, if you enjoy working with numbers and want a more accurate estimate, Method 1 is the way to go.
Method 1: Annualized Income Installment Method
You’ll want to use this method to get a more accurate calculation of your estimated taxes. This method gives a more accurate picture of your tax liability but requires more detailed calculations. It calculates your estimated tax payments based on your actual income for each period. Here’s how it works:
Estimate your net income for the period: Start with your net income for the quarter. Remember, your net income is your total revenue minus business expenses. If your bookkeeping is not current, you will find it challenging to use this method effectively. We specialize in bookkeeping for e-commerce sellers utilizing the Shopify platform. If you need help getting your finances in order, feel free to click here to learn more about our signature service, Tax-Ready Transactions.
Calculate each tax component:
Federal Income Tax: Apply the current federal tax rate to your taxable income.
State Income Tax: Apply your state’s tax rate, if applicable.
Self-Employment Tax: Calculate your net income, multiply it by 92.35% to get your taxable self-employment income, then multiply by 15.3% for the self-employment tax.
Method 2: Safe Harbor Method
If you want a simpler way to calculate your estimated taxes, consider using the Safe Harbor Method. This method ensures you avoid underpayment penalties even if your income varies year-to-year. Here’s how it works:
Find Your Previous Year's Tax Liability: Locate your previous year's tax liability on your Form 1040. You can find it on line 24.
Determine Your Payment Required per Quarter: Pay an amount equal to 100% of your taxes for the prior year. If your adjusted gross income (AGI) for the year is over $150,000, you’ll need to pay 110% of your taxes for the prior year. Take that amount and divide it by 4.
When Are Estimated Taxes Due?
Now that you know how to calculate your estimated taxes, it's crucial to pay them on time during the year. Estimated taxes are due quarterly, but notice that these are not your regular yearly quarters. These are IRS tax quarters, so pay attention to the months included. The deadlines are as follows:
April 15 for the first quarter, covering January to March.
June 15 for the second quarter, covering April and May.
September 15 for the third quarter, covering June to August.
January 15 of the following year for the fourth quarter, covering September to December.
Timely payments are essential to avoid penalties and interest charges. Remembering these dates and setting reminders can help ensure you don’t miss a payment. You may want to add reminders to your Google or Outlook calendar and set them to repeat yearly to stay on top of your tax obligations.
How to Pay Your Estimated Taxes
Lastly, we need to make sure you actually pay those estimated taxes. There are a couple of ways to do it, so choose the one that works best for you:
Online: For quick and easy payments, use IRS Direct Pay or the Electronic Federal Tax Payment System (EFTPS). It’s fast and convenient!
By Mail: If you prefer the traditional route, you can send a check or money order along with a payment voucher from Form 1040-ES.
Paying your estimated taxes on time ensures you stay compliant and avoid unnecessary penalties. Plus, it gives you peace of mind knowing you’re on top of your tax obligations.
What Happens If You Don’t Pay Estimated Taxes?
Missing an estimated tax payment can have serious consequences. If you fail to pay your estimated taxes on time, the IRS may impose penalties and interest charges. The penalty is calculated based on the amount you underpaid and the time the payment was overdue. Additionally, interest is charged on the unpaid amount from the due date until the payment is made. This is just extra money being thrown down the drain.
To avoid penalties, make sure you:
Pay at least 90% of your current year’s tax liability or 100% to 110% of your previous year’s tax liability, whichever is smaller.
Make timely payments by the quarterly deadlines.
Use IRS Form 1040-ES to help estimate and pay your taxes accurately.
If you missed a payment, pay it immediately and consult with a tax professional like me to minimize penalties.
Tip: Considering Additional Income
Now, something else to keep in mind is if you have income from multiple sources, like a full-time job and a side business, you need to consider all your income when calculating your federal and state taxes. Even if your employer withholds taxes from your paycheck, combining your salaries can push you into a higher tax bracket. Make sure to use the correct tax bracket to avoid underpayment.
Example: Imagine you work a 9-to-5 job and also run a Shopify store on the side. Your salary from your full-time job already places you in the 22% federal tax bracket. The additional income from your Shopify store could push you into the 24% bracket, resulting in higher tax rates on the combined income. Properly accounting for this can help ensure you meet your tax obligations and avoid penalties.
There you have it – everything you need to know about estimated taxes. You’ve learned the importance of estimated taxes, how to calculate them, and how to make your Q2 estimated tax payment. With this knowledge, you now have the tools to stay compliant and avoid underpayment penalties.
Remember, staying proactive with your tax obligations not only helps you manage your cash flow but also ensures you’re in good standing with the IRS. Don’t let tax deadlines overwhelm you. Set reminders, stay organized, and take advantage of the methods we discussed to make your tax payments as seamless as possible.
If you need personalized assistance or have any questions about your tax situation, please contact me. I’m here to help you navigate your tax responsibilities with confidence.
