The Boring Newsletter, 2/25/2024

Hi Friendos,

Last week I wrote about tax withholding, and possibly adjusting yours if you end up owing more, or receiving a larger refund, than what you prefer. Today’s newsletter is about paying quarterly estimated taxes, an alternative to increasing withholding.

What causes the need for quarterly estimated payments?

Self-employed people (whether full-time or part-time with gig/side job/freelance work) need to pay estimated taxes. Why? (1) to avoid owing a lot at tax time and not being able to come up with the cash, and (2) to avoid having to pay an underpayment penalty, a very un-fun way to spend money.

Another reason I’ve made an estimated payment was to intentionally overpay my taxes and use my refund to purchase I bonds. Each person is allowed to directly purchase up to $10,000 of I bonds per year, and each tax return can purchase an additional $5,000 by applying a tax refund to the purchase. If you don’t have that much of a tax refund coming your way based on other aspects of your taxes, you can intentionally “overpay” to engineer a tax refund of the size you want. I’ve made payments like this (to purchase I bonds with my tax refund) after I prepared my own tax return, but before I filed it, so I knew the exact amount of my refund.

Editor’s note December 2024: you can no longer purchase I bonds via tax refund as of January 1, 2025.

Any taxable income that has not had taxes withheld can also necessitate quarterly estimated payments.

How to actually make a quarterly estimated payment:

The easiest way is online. You go to this IRS website to make a payment, with the “reason for payment” being “estimated tax.”

• If we are already past the deadline for Q4 payments and you want to pay for the prior year, choose the reason for payment of “extension.” For example, if it is Feb 25, 2024 and you want to pay for calendar 2023, you need to choose extension because the January deadline for “estimated tax” payments has already passed.
• Do look at “Tax Period for Payment” and choose the correct one!
  • This is important when you are doing this at times of the year that allows for multiple options. For example, if it is Jan 10, 2024, I could be going online to make a payment for 4^th quarter 2023, or I could be there for 1^st quarter 2024. I have to tell the IRS which one.

If you prefer, you can also send a paper check or money order via snail mail. Save a copy of all the paperwork showing what you paid, and the next time you prepare your tax return (or have someone else do it for you), you (or they) will include info about this tax payment you made. 

If you are a freelancer and would like to read more about budgeting for estimated tax payments, here are a couple articles you can reference:

• https://www.thebalance.com/how-much-do-i-budget-for-taxes-as-a-freelancer-453676
• https://www.thepennyhoarder.com/make-money/side-gigs/freelance-taxes/

What is tax “underpayment”?

Our income tax system is pay-as-you-go, meaning you pay taxes throughout the year – you can’t just wait until the end of the year and pay in one big lump. If someone pays “too little” during the year, the IRS will assess a penalty of 2% of the amount owed (that’s on top of the additional taxes still owed). They are serious about making us pay as we go!

What exactly is “too little”? To avoid a penalty, you need to pay at least 90% of this year’s taxes owed, or 100% of your total tax bill from last year, whichever amount is less.  A stylized example: Someone has a W-2 job and freelance jobs. This year’s total income is $90k and the Federal income tax owed is $10k. Last year’s income was $80k and taxes owed were $8.5k. 

• To avoid a penalty they need to have paid taxes during the year (from withholding and/or estimated payments) that are at least [A] 90% of this year’s taxes owed or [B] 100% of last year’s tax bill, whichever is less.
• [A] 90% of this year’s taxes owed is 90% * $10k = $9k.
• [B] 100% of last year’s taxes owed is $8.5k.
• The lesser of $9k and $8.5k is $8.5k, so if the person has paid taxes (during the year) of $8.5k or more, no penalty. 

If the freelance income is small relative to W-2 income, the math generally works out so there is no penalty, especially if income goes up from one year to the next. As freelance income gets larger relative to W-2 income or if income goes down compared to the prior year, that’s where the math is less favorable.

How to avoid a penalty for tax underpayment:

If you are a freelancer, the simplest way to make sure you have no penalty for underpayment is to set money aside each time you are paid for freelance work. Then, once per quarter, send money into the IRS.

A good rule of thumb is to set aside 25% to 30% of freelance income. Aim for the higher end of this range if you live in a state with income taxes.

This might sound like a high % considering the levels of the federal income tax brackets, but freelancers also have to pay Social Security and Medicare tax (payroll taxes).  

To make it easy to set $ aside, I recommend using a separate checking or savings account where you transfers $ each time freelance income comes in.

If freelance work has associated expenses (like you buy supplies or pay for certain subscriptions that are incurred because of your freelance work), you can subtract these and only set aside 30% of what remains. You owe tax on income, not gross revenue. Revenue from freelancing minus expenses = freelance income. 

The same rigamarole can apply for state and local income taxes, but the way the math works out, it is generally more difficult to get a state penalty for underpayment from freelance income. 

Happy tax season!

-Stephanie