Back in March I was chatting with Derek – successful software engineer and collegiate soccer standout. He had a lot of questions about estimated taxes. His number one concern was, “Estimated taxes are complicated.”
Estimated taxes are a popular yet complicated area that comes up a lot for tech employees and entrepreneurs. Many times, I’ve written about them from a distance. Here is some more detailed information on paying projected taxes.
What Are Estimated Taxes?
Foremost, they are projected taxes that you pay to the federal and state governments. It sounds simple and straightforward, but it’s complex.
For our discussion, we will only cover federal taxes. There are too many scenarios when dealing with state taxes and estimated taxes are complicated. Perhaps we can discuss state taxes another time.
Estimated Taxes Are Complicated
Next, there are a few rationales regarding estimated tax payment – avoid tax penalties and prevent a surprise tax bill on April 15th.
First, you avoid tax penalties. You are penalized when you pay taxes late or you don’t withhold a sufficient amount of taxes from your income. To make matters worse you will have to pay interest on the amount of late taxes.
When you pay taxes at the right time, you ward off a lot of stress migraines. However, avoiding tax penalties doesn’t require you to pay all the taxes due on the income. You may still have another tax liability on April 15th. Confused?
Next, the second motivation is to pay all the taxes due on the income and avoid a large and surprising tax bill on April 15th. Unfortunately, this happens to many tech employees.
Typically the number one reason for an unexpected tax bill on April 15th is that withholding taxes are too low on various forms of equity compensation throughout the year. They are not so low that there are tax penalty payments but low enough to warrant an unexpected and sometimes large tax bill!
Moreover, if you experience a high income year, you may owe $50,000 or even $100,000 in unexpected taxes. How often do you have this amount of cash lying around?
Scenarios When You Should Pay
To begin with, there are many situations when you should consider paying estimated taxes. These include:
- When you receive Restricted Stock Units (RSUs)
- Your company completed an IPO
- Exercising stock options
- You have self-employment income
- Paid a bonus
Each of these scenarios and explanations is rather long, so if you’d like to walk through some of them, we can set up some time to speak.
How Much to Pay
Then you decide how much to pay. That depends on what you want to do: avoid penalties or be diligent with your tax bill?
You have two options to avoid penalties. One, pay at least 110% of the tax from the previous year. Two, pay 90% of what you owe in the current year, but this amount is difficult to calculate. This 110%/90% payment is known as the safe harbor rule for estimated taxes.
Although you avoid penalties by paying taxes on time, you can still have a surprise tax bill on April 15th!
Timeline
Throughout the year, the deadlines for paying estimated federal taxes are:
- April 15th
- June 15th
- September 15th
- January 15th
Work with a CPA
Estimated taxes are complicated. Please consult with a CPA to determine the appropriate tax you must pay to avoid penalties and disappointing tax bills on April 15th.