If you’re self-employed, collect alimony, receive rental or investment income, or even win big in Vegas, both the IRS and your state revenue office get a piece of the pie. If you haven’t set aside Uncle Sam’s portion, you’ll be miserable come April 15. Don’t worry — if you’re behind on covering these tax payments, you can still catch up. You can also make sure that it never, ever happens again. You can do it with estimated tax payments.
How It’s Supposed to Work
It’s an incredible feeling to get extra cash that doesn’t come from your employer. In the best-case scenario, you set aside the tax you owe on that money as soon as you get it. Here are a couple of situations that would require estimated tax payments.
If you get income from an employer in addition to receiving alimony, you’ll pay taxes on your alimony payments as well as your employment income (yes, alimony is taxable). The easiest way to handle it is to fill out a new W4 with your employer, increasing your withholding for a sufficient amount to cover the alimony income. Use the IRS withholding calculator to estimate how much tax you’ll owe, including your alimony in your income totals. Then, submit a new W4 to change your filing status to single or head of household, and ask your employer to withhold an additional monthly amount to cover taxes on alimony.
2. Gambling Winnings
Casinos usually withhold winnings for certain games, including slots, poker tournaments, bingo, and keno. Racetracks also withhold some of your winnings on the horses. When the house withholds taxes, you complete Form W-2G and file it with the IRS. However, some casino games, including table games like blackjack, craps, roulette, and baccarat, don’t require the casino to withhold money and file a W-2G. In these cases, you have to withhold the tax money yourself.
3. Rental or Investment Income
Before estimating what you’ll owe for rental and investment income, talk to a professional tax advisor. The tax you owe will depend on more than just how much money you collected. With a rental property, you can deduct certain maintenance expenses and depreciate your property, which might completely offset your rental income. With investment income, if you had a loss in the prior year, it can offset your gains in the current year. You’ll also want to increase your withholding tax in the event that you receive a substantial amount of either taxable interest or dividend income, or both.
If you collect all or part of your income from self-employment — including those times you made extra money because of a hobby — then you should make estimated tax payments. Fill out Form 1040-ES and make four payments per year. As long as you pay either 100 percent of last year’s tax or 90 percent of the current year’s tax, you won’t be liable for a penalty.
5. Sub-contractor Income
This type of income is becoming more prevalent all the time, as employers look to avoid payroll expenses, such as matching FICA contributions and employee benefits, like health insurance or retirement contributions. Instead of paying employees by W2, complete with withholding tax, they convert the employees to sub-contractor status, which shifts the tax withholding burden completely to the employee.
Most of these sub-contractor arrangements are not even IRS compliant, but they are nonetheless very common. (The IRS has something on the order of 20 “tests” to determine the legitimacy of a true sub-contractor arrangement, and if it fails even one of them it isn’t in compliance). If you have such an arrangement with your employer, you will need to set up income tax estimates with the IRS, in much the same way you would if you were self-employed. In fact, as income taxes go, you are self-employed, and will need to proceed accordingly.
6. Capital Gains
This has become a significant income source for many taxpayers given the bull market in stocks over the past six years. Many people are reporting substantial capital gains income each year, especially since capital losses from the 2007-2009 bear market have largely been used up. Capital gains generally carry lower tax rates than ordinary income, and sometimes no tax liability at all (the capital gains tax is zero if you are in the 15% tax bracket or lower).
However, if you’re in a higher tax bracket, your capital gains tax can be 20% of your gains. If your total gains are $100,000, that will translate to a $20,000 tax liability on your federal return, plus your state income tax return – and states generally do not provide reduced income tax rates for capital gains, like the IRS does.
If you have large gains, you will need to provide adequate estimated tax payments to cover the additional income. It’s also best done upon the receipt of a large capital gain, since you’ll have the money available. If you delay making your estimated payments until a later date, the money from the capital gain may not be there. It will also help you to avoid penalties and interest charges, since the IRS calculates tax liability based on date of receipt of the income.
What Happens When You Fall Behind
If you should be making estimated tax payments and you haven’t, you could be subject to a penalty. The IRS usually charges a flat percentage of the unpaid tax liability, plus a certain amount based on the number of days your payments are late. If you’re self-employed and haven’t made estimated tax payments, you’ll owe both taxes and penalties on April 15. If you can’t foot the entire bill at tax time, here’s what you can do:
- Pay what you can. Pay part of the tax to both the IRS and your state revenue office. The sooner you pay, the quicker you’ll stop accumulating penalties.
- Calculate penalties and interest. After you calculate the penalties and interest that you’ll owe, compare it to what you’d pay to charge your taxes to a credit card. In some cases, the IRS charges more for penalties and interest than the bank charges for your credit card. You might also pay less if you take out a personal loan to cover your costs.
- Set up an installment plan. For people who don’t owe a lot of taxes, an installment plan will cost less than charging the tax owed to a credit card. You’ll pay a small fee to set up the plan, and then the IRS and state revenue office will deduct from your bank account every month. Pay as much as you can afford every month until the tax is paid off.
You can’t discharge IRS debt even in bankruptcy, so don’t mess around by paying taxes late. Make estimated tax payments, fill out your W-2G, or adjust your W4 as quickly as possible.