Why You Need to Pay Estimated Taxes

Taxes. Blech.

It’s a topic that most of us happily avoid discussing, but like them or not, they’re a reality. When you’re employed by a business, you know that you have taxes withheld from your paychecks. Depending on your state, federal, state, and/or city taxes are withheld. You file the W-2 form, and the accounting team with your employer takes care of those withholdings for you.

But what about when you’re self-employed?

Here’s the reality: You still have to pay taxes.

I’m sometimes surprised when people who are self-employed don’t realize they need to pay taxes. Trust me when I say that I’m the last thing from an expert on this topic, but this is something I learned about very early on when preparing to launch by business, and I’ve dutifully paid estimated taxes every quarter since launch. So, when I come across someone who doesn’t know what estimated taxes are and is unaware that they need to be paying them, I get a little worried for them.

What are estimated taxes?

Estimated taxes include the money that you withhold from yourself to pay to the IRS. Just like what would happen if you were employed by a business, you must withhold taxes from yourself and pay the IRS. They run on a quarterly schedule, but it’s not so “quarterly,” in my opinion–some “quarters” are longer than others. It’s not an even split of every three months. Regardless, the IRS still expects you pay them each quarter that they’ve defined. Here are the quarters and due dates:

• For January 1st to March 31st, pay by April 18th
• For April 1st to May 31st, pay by June 15th
• For June 1st to August 31st, pay by September 15th
• For September 1st to December 31st, pay by January 17th of the next year

You can read more about the deadlines and other pertinent information here.

What happens if you don’t pay estimated taxes?

In the event that you don’t pay estimated taxes each quarter, you can be penalized. I’m not sure what that penalty amount is; the IRS website doesn’t list it. However, it’s important to note that if you think you’ll owe less than $1,000 in taxes (after your withholdings and credits), you don’t have to pay estimated taxes. You can read more about this here on the IRS website. This would really only occur if your business/income is quite small, I would think. This penalty will “show up” when you file your taxes.

How much should you pay in estimated taxes?

I did a fair amount of research on this when I was preparing to launch my business. Estimates varied between withholding 20% and 30% of your income, so I split the difference and withheld 25% for the first 16 or so months of business. However, I’ve since had some realizations, thanks to my new accountant. He informed me that self-employment tax is 15.3%. So, you definitely need to withhold that percentage from your business income. However, you also need to take your income tax bracket into consideration. The charts on this IRS page should help you determine the additional percentage of money that you need to withhold from your business income. Therefore, the range would be anywhere from about 25% to almost 55%, if you’re really raking in the big bucks!

For the 2015 tax year, I actually received a massive income tax refund–the largest I’d ever received. (I was really surprised but thrilled, obviously, as we’d literally just bought our first home.) However, I’d also held three jobs in 2015–two with other employers and then my own business, which I launched that year. I’m not sure how much of that refund was from my own business as opposed to the other two jobs. I could probably figure it out, but…meh. In 2016 I held two jobs, one of which is my business. I’m hopeful for another sizable income tax refund, of course, as I continued to set aside 25% of my earnings for estimated taxes until the end of 2016. I’m curious to learn what will happen when I file in 2018 for the 2017 tax year, as 2017 will be my first year reporting entirely self-employment income.

How can you prepare to pay estimated taxes?

I’ll talk about this more in another blog post, but I have completely separate business bank accounts. (If you don’t, do this now!) Of course, I have my personal checking and savings accounts, and then I have separate business checking and savings accounts. Almost everything business-related comes into and out of my business checking account, but I use my business savings account for estimated taxes.

Every time I earn income, I calculate 25% of the total, and then I transfer that amount of money to my business savings account. I continue to accrue money in there until it’s time to pay estimated taxes for the quarter, at which point I transfer the money from my savings account into my checking account to make the payment. I usually go back through my income for the quarter and double-check that I’ve withheld 25% before making the payment.

Why should you set up a similar system? Because you don’t want to come to the end of the quarter and make that calculation and then think, “Gee, where am I going to come up with $2,500 (or however much) to make this estimated tax payment?” You want to be setting that money aside all along so that when the time comes to make that payment, you already have it. You don’t have to scramble a couple grand together at the last minute and end up straining yourself financially. This is even more imperative when you consider facing this at tax filing time, if you didn’t pay any estimated taxes the previous year. You could be faced with owing in the five digits (or more) and not have any of that money set aside and ready to pay! Needless to say, this is definitely not a situation in which you want to find yourself.

How do I pay estimated taxes?

You’ll need to make an account with the Electronic Federal Tax Payment System, or EFTPS. If you’re a sole proprietor and even an LLC–especially a SMLLC, I’d think–you’ll simply use your social security number to file, because your business isn’t considered to be separate from yourself. But if you’ve set up your business as an LLC that files as an S-Corp or as a straight S-Corp or C-Corp, you’ll need an Employer ID Number (EIN), issued by the IRS (as far as I know). You can read more and learn how to apply for that here.

Once you’re all set up on EFTPS, you simply login before the quarterly deadline and make your payment electronically. You’re issued a pin number that you’ll use each time you login, and you can print or save documentation of your payment for your bookkeeping and accounting records. It’s very quick and simple to do…as long as you’re prepared!

How do you make sure you’re prepared to pay your quarterly estimated taxes? Let me know in the comments!

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