Understanding Estimated Tax Payments and Tax Withholding

As taxpayers in the United States, we follow a "pay-as-you-go" system, which means we are required to pay taxes as we earn income. Employees usually accomplish this by withholding taxes from their paychecks, whereas business owners or those with investment income typically make scheduled estimated tax payments throughout the year.

Key takeaways

• Taxes generally must be paid throughout the year as income is earned or received, whether through withholding, estimated tax payments, or a combination of both.

• Estimated tax payments are primarily used by taxpayers whose income is not subject to withholding or whose withholding is not sufficient to cover their expected tax liability.

• Federal estimated tax payments for calendar-year individuals are generally due four times per year: April 15, June 15, September 15, and January 15 of the following year. State estimated tax deadlines may differ.

• Federal safe harbor generally refers to tax payment thresholds that can help taxpayers avoid an underpayment penalty.

• Retirement account distributions can generally have taxes withheld at the time of the distribution.

Why do I have to pay taxes throughout the year?

Taxpayers generally must pay tax as income is earned or received throughout the year. An underpayment penalty may apply when a taxpayer does not pay enough tax through withholding and/or timely estimated tax payments during the year. The calculation considers both the amount and timing of required payments.

How does tax withholding work for employees?

Employee pay stubs show the amounts withheld from each paycheck: federal tax, state tax (if there is one), Social Security tax (OASDI), and Medicare. Employees can generally adjust their federal income tax withholding by submitting a new Form W-4 to their employer. State income tax withholding may also be adjustable, depending on the state.

What are estimated tax payments, and who makes them?

An estimated tax payment is a manual payment to the U.S. Treasury or a state tax department. Anyone can make estimated tax payments, although they are primarily used by taxpayers who receive income that is not subject to withholding or whose withholding is not sufficient to cover their tax liability.

Taxpayers who are likely to make estimated tax payments include those with:

• Business income

• Rental income

• Dividends and interest

• Capital gains

• Prizes, awards, or other taxable income

When are estimated tax payments due?

For calendar-year individual taxpayers, federal estimated tax payments are generally due four times during the year:

April 15: for income earned January 1 through March 31
June 15: for income earned April 1 through May 31
September 15: for income earned June 1 through August 31
January 15 of the following year: for income earned September 1 through December 31

If a due date falls on a weekend or legal holiday, the deadline generally moves to the next business day. Special rules can apply to certain taxpayers, including those in the farming and fishing industry as well as fiscal-year taxpayers. State estimated tax deadlines may differ.

How do I make an estimated tax payment?

Federal estimated tax payments can be made electronically through IRS payment options such as IRS Direct Pay. Taxpayers can also currently mail estimated tax payments, although the IRS strongly encourages electronic payment methods and is reducing its reliance on paper payments. Most states also offer online portals for making state tax payments.

What is safe harbor?

Estimated tax payments are often, but not always, made to achieve what is known as safe harbor. For federal individual income taxes, safe harbor generally refers to payment thresholds that can help taxpayers avoid an underpayment penalty.

For federal individual income taxes, the general required annual payment is the smaller of:

• 90% of the current-year tax, or

• 100% of the prior-year tax (110% of the prior-year tax when prior-year AGI exceeds $150,000, or $75,000 if married filing separately).

Generally, individuals are not required to make estimated tax payments if they expect to owe less than $1,000 in tax for the year, after subtracting withholding and refundable credits.

Determining the applicable safe harbor amount can involve a taxpayer's prior year adjusted gross income (AGI), prior year tax, and projected current year tax. Because current year tax liability isn't known until the year is complete, proactive tax planning can help estimate whether payments based on projected current year tax are appropriate.

For example: DeAnne owns 100% of an S corporation that operates a manufacturing business. The business generated $2 million in income last year. This year, significant equipment purchases and related tax deductions are expected to contribute to a reduction in taxable income, and DeAnne's projected business income is $1.2 million.

Because DeAnne is a high-income taxpayer with AGI exceeding $150,000, one potential federal safe-harbor calculation may be based on 110% of her prior-year tax. However, if her current-year tax liability is expected to decline significantly, relying on the prior-year safe harbor could result in substantially larger payments than necessary to satisfy the alternative 90%-of-current-year-tax threshold.

Proactive tax planning can help compare these approaches. Paying based on the prior year safe harbor may provide certainty, while a properly calculated current year estimate may allow DeAnne to retain more cash in the business or her personal accounts during the year.

Can tax be withheld from retirement account distributions?

In most cases, yes.  Taxpayers can generally elect to have federal income tax withheld from retirement account distributions. Depending on the account and type of distribution, different withholding rules may apply. State withholding rules also vary.

How do I figure out the right amount to withhold from my Traditional or Rollover IRA?

We often start by asking clients how much they would like to have in their bank account, which is the net distribution. From there, we work backwards to determine how much the gross distribution needs to be, which is the net distribution plus the amount for taxes.

Here is a simple equation to help determine the gross distribution if the applicable federal and state tax rates are already known:

Gross distribution (pre-tax amount) = net distribution ÷ (1 − tax rate).

For example:
Zach is 61 years old, lives in Vermont, and is requesting a distribution of $30,000 for a home project. For purposes of this simplified example, assume tax planning indicates that Zach should use a 25% federal withholding rate and an 8% Vermont withholding rate, for a combined assumed withholding rate of 33%.

Amount Zach needs in his bank (net distribution): $30,000
Tax Rate: 33%
1 – Tax Rate: 1 - 0.33 = 0.67
Gross distribution: 30,000 ÷ 0.67 = $44,776.12

This simplified calculation assumes the selected withholding percentages accurately approximate the taxes attributable to the distribution. Actual tax liability can differ due to other factors such as deductions and credits. Additional income can also have secondary tax and financial implications, such as increasing Medicare Income Related Monthly Adjustment Amounts (IRMAA) and/or reducing certain income-based deductions or credits.

Frequently asked questions

Why do I have to make tax payments during the year?
Taxpayers are required to pay as they earn income, a system the IRS refers to as "pay as you go." Estimated tax payments are an option for taxpayers to pay their required tax if they don’t have the option to withhold taxes from their earnings.

How do I change my tax withholding?
IRS Form W-4. It is shared with your employer or sometimes updated through a portal your employer provides.

Who should make estimated tax payments?
Anyone can, but they are intended for taxpayers with a tax liability in excess of their withholding capability or income that has no option for withholding, such as business owners or those with dividends, interest, or awards.

How often are estimated tax payments due?
Federal estimated tax payments for calendar year individuals are generally due four times per year: April 15, June 15, September 15, and January 15 of the following year. State estimated tax deadlines may differ.

Can I still pay estimated taxes by mailing a check?
The IRS currently continues to accept mailed checks and money orders, although it strongly encourages taxpayers to use electronic payment methods. Federal payment procedures continue to evolve, so taxpayers should check current IRS guidance before mailing a payment.

What is safe harbor?
For federal individual income taxes, safe harbor generally refers to payment thresholds that can help taxpayers avoid an underpayment penalty.

Can I make estimated payments for retirement distributions?
You can, although it is often easier to withhold taxes at the point of the distribution.

The bottom line

This post covers just the top layer of estimated tax payments and tax withholding. For questions and inquiries specific to your situation, be sure to reach out to your tax professional.

This article is provided for informational purposes only and should not be construed as legal, tax, or financial advice. The information presented is based on sources believed to be accurate and reliable. However, economic conditions, laws, and regulations are subject to change, and the information may no longer be true. Any examples provided are for illustrative purposes only and are not intended to guarantee or imply that similar results will be achieved. The information contained in this article is also not intended to constitute, and should not be considered a substitute for, personalized investment advice from Pathway Financial Advisors, LLC. A current or prospective client should not view this article as a guarantee of any particular level of investment performance or satisfaction if Pathway Financial Advisors, LLC is engaged, or continues to be engaged, to provide investment advisory services. Readers should consult with their financial advisor or other qualified professional before making any investment decisions.