Estimated Tax

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Estimated Tax Definition

Estimated tax refers to the tax arrangement that makes individuals pay taxes in proportion to the income they generate from their self-employed ventures. These taxes apply to freelancers and any independent artisan or contractor whose earnings are not subject to withholding. It allows self-employed taxpayers to pay a portion of their earnings as tax to the government.

The individuals or firms determine estimated tax with respect to what the taxpayers earn over a period. Individuals and firms pay these taxes quarterly, helping the government authorities generate significant revenue. The Internal Revenue Service (IRS) expects the independent business operators to pay these taxes every quarter within the due date.

Estimated reading time: 10 minutes

Key Takeaways

  • Estimated tax refers to the tax system for self-employed and independently working individuals.
  • Based on their earnings, they calculate the tax based on the tax brackets for the current fiscal year and pay their part as tax.
  • In the United States, individuals use Form 1040(ES) to calculate their taxes, while corporations use Form 1120-W.
  • Individuals/companies are subject to paying penalties for underpayment of the taxes. However, these can be avoided under certain circumstances.

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How Do Estimated Taxes Work?

Estimated Tax

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The estimated tax applies to those individuals whose income is not subject to withholding. In a regular tax structure, employers deduct the income from employees’ payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more at regular intervals to serve their local, state, and national tax payment responsibilities. However, self-employed people who work independently have no specific tax structure to follow. As there are no higher authorities to deduct or withhold their taxes from the payroll, these individuals pay a portion of their earnings as taxes through estimated tax payments.

The IRS expects self-employed individuals to pay these taxes if they incur a tax liability worth $1,000 for that year. Moreover, if it’s a partnership business, the individuals are subject to paying taxes worth over $500.

Regular employees have to fill up a W-4 tax form to help employers know how much tax to withhold. The recruiters take the details at the time of hiring to deduct the tax amount from their earnings before they issue the paychecks.

The IRS further assesses the payable estimated tax to check whether the amount paid as tax is accurate, less or too much. While filing the estimated tax return at the end of the financial year, if the taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more find that the payment was too much, they can apply for an estimated tax refund

The proof of income may include salary receipts, capital tax gains, interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, coupon receipts, self-occupation, or any other form which adds to the net amount available with the individual or company. In addition, individuals or companies with unequal monthly income may annualizeAnnualizeIn investments terminology, annualize is a method of estimating the financial performance of a short-term investment on an annual basis. In simpler words, investments yielding short-term returns for semi-monthly, monthly, or quarterly periods are considered for annualization.read more their income to calculate the total income received during the year.

Applicability

In the United States, individuals use Form 1040(ES) to calculate their taxes, while corporations use Form 1120-W. While filling up the form, taxpayers disclose all incomes and deductions and calculate this amount accurately. In the case of excess tax payments, the amount can be recovered after the end of the current fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more through return filing.

Individuals or companies are exempted from paying the estimated tax for a particular year if they meet all the below-mentioned conditions:

  • They have zero tax liability for the previous year
  • They resided and operated in the U.S. for that entire year
  • Their prior tax year included all 12 months

Examples

Let us consider the following estimated tax examples for an in-depth understanding of the concept:

Example #1

John works for ABC Corp and earns $100,000 annually. He has been paying $1,000 as withheld taxes each month to his company. His child has expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more worth $5000. He has invested in T-billsT-billsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more securities, which are projected to earn him an income of $2,000 during the year. Let us calculate the estimated tax for the current year for John. 

Example 1

Based on his income, John falls under the bracket of 24%.

estimated tax

John has to pay a tax of $20,400 annually (or $5,100 quarterly).

Example #2

In the above example, consider the below-added information for John and re-estimate the taxes he owes:

  1. Education loan of $30,000.
  2. Interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more of $30,000
  3. Medical Expenses: $5,000
Example 2

John falls into the bracket of 12%.

estimated tax 1

John has to pay a tax of $2,400 annually (or $600 quarterly).

Estimated Tax Penalty

If individuals or firms do not pay the estimated tax properly throughout the year, they are subject to paying the penalty for underpayment. Most of them try to avoid paying the penalty by presenting documents to prove their tax liability is less than $1,000. 

In addition, if taxpayers pay around 90% of what they owe or 100% of the tax as indicated on the return for the previous year, they can still avoid the penalty based on whichever is lower. One can avoid the penalty if the estimated tax payments become due because of a casualty or unusual circumstances. If a taxpayer retires at the age of 62 and above or becomes disabled during the tax year, the penalty remains inapplicable.

Advantages

Through these taxes, self-employed individuals remain accountable for their tax liabilities and get an opportunity to contribute their part in maintaining the nation’s economic ecosystem. Here is a list of advantages of such taxes:

Estimated Tax Advantages

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Disadvantages

While the estimated tax has numerous advantages, it does have a few limitations, which include:

Estimated Tax Disadvantages

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  • Tax evasion is quite common when it comes to paying these taxes. As there is a possibility of the actual income proof being hidden, companies and individuals might skip paying taxes, distorting the supposed returns from the nation for the government.
  • In the process, taxpayers might unintentionally miss out on counting on many incomes generated from a few sources. As a result, it is difficult to calculate the exact tax amount as the income might not always be accurately computed. 
  • There is no verification system to check if the taxpayers pay accurate taxes. Though the proof of income is checked to see if the tax paid is accurate, the process is time-consuming. 
  • Income tax rates are static for the year. If the annual income changes during the year, the taxes do not change for the year. The taxpayer still pays the same amount as he did in the beginning.

Frequently Asked Questions (FAQs)

What is the estimated tax?

It is a self-paid tax, which independent contractors, freelancers, and self-employed individuals pay to contribute to the government. Based on the income generated throughout the year, companies and individuals calculate their share of tax and pay it if the payment they owe is at least $1,000.

When is the estimated tax due in 2022?

These taxes are paid quarterly, with the first quarter being Jan 1 to Mar 31, the second quarter being Apr 1 to May 31, the third quarter being Jun 1 to Aug 31, and the fourth quarter being Sep 1 to Dec 31. Accordingly, the taxes are due on Apr 15, Jun 15, and Sep 15 of 2021, and on Jan 15, 2022.

Where to pay estimated taxes?

Taxpayers can make these tax payments with Form 1040-ES by mail or other online means using phone or mobile devices. For example, they can use the IRS2Go app and follow the instructions. They can also use the Electronic Federal Tax Payment System (EFTPS) for paying federal taxes.

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This article is a guide to what is Estimated Tax, its definition & examples. Here we explain the return, refund, and penalty details with due dates 2022. You can learn more about Accounting from the following articles –

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