Independent contractors, sole proprietors, and other self-employed individuals who practice a profession or run a business need to prepare their income tax before the tax season arrives. The most common question self-employed taxpayers have is how to make estimated tax payments. How do you figure out your total earnings for the year when you have just started? Paying less than what you owe the IRS will surely get you in trouble, as there is an underpayment tax penalty. But is overpaying your taxes bad, too?
To learn more about overpaid taxes, you need to familiarize yourself with the estimated tax concept. In this post, we will walk you through everything you need to know about estimated tax, who’s supposed to pay it, when it is due, and how you calculate it. Keep reading.
What is Estimated Tax Payment?
The federal laws and IRS has introduced a pay-as-you-go tax system. Instead of waiting for the end of the financial year, you pay taxes as you earn income. Basically, Americans pay taxes every quarter, either in the form of withholdings or paying from their income. You don’t have to worry about the taxes if you work for someone, as your employer handles that part. Every quarter, your employer withholds a small percentage of your salary for Social Security and Medicare tax. But what if you are self-employed?
As your income isn’t withheld for the tax, you are supposed to pay the estimated tax quarterly. As the name suggests, estimated quarterly tax payments are based completely on your estimated income. You don’t have to do the guesswork, but use your previous year’s tax bills to arrive at the estimated income. If it’s your first year filing income tax as a freelancer or independent contractor, you need to guess your income based on what you have earned so far.
First things first, self-employment tax is paid separately from your income tax, and it applies to every employee who reports an income of over $400 from different sources. Failure to file and pay your quarterly tax can result in penalties.
Who Pays Estimated Tax?
Anyone who doesn’t have a fixed percentage of their income withheld from their quarterly or annual salary for income tax needs to make estimated tax payments. To be liable for this tax, you should report an income exceeding $1,000 for the annual year.
Mostly, self-employed individuals have to make estimated tax payments unless they have a source that withholds their income for tax payments. On the other hand, employees get a Form W-2 from their employer that states the amount withheld from their income for tax purposes. You don’t have to worry about filing an estimated tax returns form if you receive form W-4 from your employer.
If you make an income from any of the below-listed sources, you have to make quarterly tax payments.
- Income from the sale of a property
- Retirement accounts
- Alimony
- Income from investment
If your income is withheld from your paycheck, but you have a side gig that earns you more than $400, you need to file estimated tax payments. Alternatively, you can fill out Form W-4, requesting your employer to increase the taxable amount withheld from your income.
A common misconception about income tax is that you can pay it in a lump sum at the end of the year. If your taxes due are equal to or above $1000, you need to pay them throughout the year. This is split into four payments every quarter, and missing even a single tax payment can result in penalties.
Can Overpaying Taxes Get You in Trouble?
Fortunately, tax overpayment won’t result in any penalties. If you have overpaid taxes, you don’t owe any balance. Instead, you will be eligible for a tax refund equal to the overpaid amount. The condition applies to employed individuals who withheld more than they were liable to pay for the quarter and self-employed taxpayers who overestimated their income.
The only downside to tax overpayment is that you let the IRS keep your money for a long duration. The same is not the case with underpayment. Tax underpayment can result in penalties, even if you delay it by one day. The interest is also added to the tax payment.
Another relief is that the IRS allows the first mistake. If it’s the first time you are filing estimated tax, and you have underpaid, you will not be subject to interest or penalty. The rule is only for taxpayers who didn’t file income tax for the previous year.
There are two options for taxpayers who’ve overpaid the estimated quarterly taxes:
- Ask the IRS to send you the balance as a tax refund.
- Adjust the balance in the tax payment for next quarter.
Now, how do you get the refund?
At the end of Form 1040, there is a section for refunds. You can find it on line 34. You need to mention where you’d like the refund to be transferred and submit your bank account details to get the amount credited. The IRS will process your refund within 8-10 weeks of your application (sooner than that, mostly). If they take longer than 45 days to send you a refund, you will get an interest along with it.
Are You Notified if You Overpay Your Estimated Tax?
It’s normal for self-employed individuals to overpay the estimated tax, as you never know how much you will earn in a financial year. The market trends, your expansion goals, changing economy, and other factors can significantly impact your income.
You would not get a notification from the IRS if you paid more than you owed or a larger than required amount is withheld from your paycheck. You will know it on your own when filling out Form 1040. If you notice a difference between the actual and owed amounts, ask the IRS for a refund immediately. The IRS, however, notifies taxpayers who are eligible for tax credits but did not claim. The IRS sends a notice showing you the refund amount. It might ask for additional information before transferring the refund.
Another option is to use the extra as your pre-payment and adjust the balance in the next quarter. On the same form, on line 36, there’s an option that asks if you’d like the overpaid amount to be transferred to the next payment. You can transfer the full refund amount for the next payment or a portion of it, whichever seems suitable. Just mention the total amount you want to transfer to the next year, and you are good to go!
How can You Avoid Estimated Tax Overpayment?
Calculating your estimated income is pretty challenging, let alone figuring out the tax payments after applying deductibles. Still, there are a few practices you must follow to avoid overpaying your income tax.
Start with the deductions. The IRS has allowed many business expenses as deductibles to lower your tax burdens. There’s a good chance you might not be familiar with each deductible, especially after the Tax Cuts and Jobs Act came into effect. So, your best option is to leave this task to a professional accountant or use an AI tax calculator to get the numbers right.
Make sure your estimated tax payments are calculated from your net income, which is achieved after subtracting your business expenses from the adjusted gross income. If you are still having trouble with deductions, you should take a standard deduction instead of itemizing them. A standard deduction allows you to deduct a specific amount (set forth by the IRS) from your taxable income. For instance, the standard deduction amount is $12,950 for 2022 for individuals or married couples filing separately.
Use AI Tax Calculator
Calculating your yearly income tax is comparatively easier than estimated tax payments, as there’s always a risk of underpayment and overpayment. You might end up paying less than you owe or more than that. While there’s no problem with an overpayment, paying less than the required amount can lead to penalties. So, always use your previous year’s tax bills to figure out the estimated income for the year and pay accordingly.
If you are not sure about estimated tax payments, use the AI tax calculator. Once you have linked your purchases to the app, it will automatically detect the allowed deductibles. You are then asked to accept or reject the deduction. The calculator eases your tax calculation burden by doing all the complex math work. With an AI tax calculator, there is a good chance you won’t overpay your taxes.
Hire a Professional Accountant
If that doesn’t look viable, you can work with a tax accountant who knows the ins and outs of the latest tax regulations. Since accountants are aware of all deductions, they will help you make tax payments in full.
Still, worried about overpaid estimated tax? No need to worry. You can request a full refund or get a partial amount in the refund and transfer the rest to the next year’s dues.