My fancy degree doesn't buy me tax sense

June 12, 2007 11:54 PM

Another tax question by and for the self-employed...help me pay my quarterly estimated taxes correctly!

I apologize in advance for the idjit-ness. I keep doing searches on MeFi and coming up confused....

I finished grad school in 2006, and went from earning $22K a year as a student to an independent contractor earning nearly four times that annually in 2007 (but started working only couple of months ago after being a lazy bum for a few months - hence the first quarterly tax payments on June 15). On the upside, I suppose I could afford an accountant now - but I'm stuck in my poor student ways.

Come Friday, do I only owe some portion (a third?) of my total tax from last year, even though it's waaaaay smaller than what I ought to owe this year? Or am I required to pay a third of what I expect to owe for 2007? According to the 1040ES, I think it's the former to avoid underpayment penalties, but it seems weird to pay only a couple hundred bucks when overall for 2007 I'm going to owe something on the scale of tens of thousands of dollars

I know that at some point I will have to pay taxes on the new salary, but I just moved and don't know if i can afford it yet; I'd rather wait until my emergency fund has been built back up (and put off paying the bulk of these taxes until next April and stash money in a high interest savings account to do so until then).

Oh, and I'm in the United States.

posted by universal_qlc to work & money (9 comments total)

Also, yes, I have read Pub. 505; I declare it to be damn confusing!
posted by universal_qlc at 11:56 PM on June 12, 2007

Yes, just pay up to what you paid last year and you'll be fine.
posted by bigmusic at 12:25 AM on June 13, 2007

Did you get a refund last year?
posted by ikkyu2 at 12:37 AM on June 13, 2007

Yep, if your 07 AGI will be less than $150k, as it sounds like it will, you're safe from a penalty as long as you pay 100% of your 06 liability. (The rule for >150k is 110% of the previous year.) If your income had been constant throughout the year, you would have paid 1/4 of this in in April, and in theory that's what the IRS will think was due then if you don't let them know that they should think otherwise.

If you don't pay the right amount on the right day, you can be liable for a penalty. However, 1. It's really not clear to me how often the penalty assessed, as I have friends who pay estimated who say they have skipped payments, not paid a penalty, and not gotten in any trouble 2. Given the income off which your 06 taxes were based, any penalty would likely be small, and 3. If you want to do this by the book, and make sure the IRS knows you were in the right when you didn't pay the first quarter, you can use the Annualized Income Installment Method (described in pub. 505) to compute what your tax payment should be for this and the remaining quarters. I've never had to do it, but my understanding is that if you work through those sheets, you'll find out how much you are actually supposed to be paying this quarter. It looks like a fun worksheet, and maybe some one with experience here can say whether you should actually bother with it rather than just paying some reasonable sized chunk now.

But yeah, you will get hit with a relatively large bill come 1040 time if you do it this way. That should be fine, if you're the planning ahead type. Otherwise, it might be worth kicking a little extra in in the next two quarters if in the mean time, your bank account grows enough to make that comfortable.
posted by epugachev at 1:01 AM on June 13, 2007 [1 favorite has favorites]

lkkyu2: yep, i did get a refund last year. It was sweeeet. Except I had to use it to move.
posted by universal_qlc at 1:17 AM on June 13, 2007

universal qlc: here's my understanding, which I am not an accountant, so take it as you will.

Basically you're tasked with keeping up to date with your taxes in a quarterly way. You are supposed to pay estimated tax each quarter on the deadline, and there's a formula to use if you believe that your income will be uneven throughout the year. If you don't pay on time, come the end of the year you're liable for penalties, which are calculated on a pro-rated basis depending on not only how much you owe overall, but for how long each payment was delinquent.

Here's the kicker, though: if you receive a refund in year N, the penalties for failure to pay estimated taxes in year N+1 are not assessed. You'll have to pay all the accrued tax liability before April 15, N+2, when you file for year N+1, though; so you won't get a refund that year. Thereafter, you *will* be on the hook for paying your estimated taxes correctly in year N+2.

This is kind of weird to me: You're not actually legally off the hook for paying your estimated tax. The IRS quite clearly says you're supposed to pay it on time. It's just that there's no penalty assessed if you don't do it in the year after you got a refund; as long as you get it all in by the next April 15th.

Again, not certain this applies to all circumstances.
posted by ikkyu2 at 2:03 AM on June 13, 2007

if you are a contractor and you are really making enough to afford one, it does behoove you to get a good accountant (esp one with a lot of clients in your field). unless you are really good at that stuff yourself. a good one will be able to save you the most not to mention be able to advise you in the best way.
posted by violetk at 4:47 AM on June 13, 2007

Listen to violetk. When I started contracting, I hired an accountant the first year, he found lots of deductions that I didn't even know existed, and then I used the return he prepared as a template to do it myself in future years. Over time, the money I spent on the accountant easily paid for itself 10 times over.

As an example, if you can avoid paying $10,000 in estimated taxes, and instead put that money in a money market account until April 15, 2008, you can make a few hundred dollars in interest. That'll help cover the cost of getting professional advice now.
posted by fuzz at 5:47 AM on June 13, 2007

When you have a rising income and your deductions don't change substantially, the easiest and least costly way to pay estimated taxes is to just pay 1/4 of your previous year's taxes each quarter (safe harbor rule). You will end up owing on April 15, but you get to hang onto your money longer. Just make sure you set aside enough to eventually pay your taxes.

The IRS just gets a 1099 at the end of the year indicating your total income, so they have no way of knowing if you have an uneven flow of income without doing a full audit. Your goal is to reduce the probability of an audit. You can do this buy simply paying 1/4 of the previous year's tax each quarter. Since you already skipped the first payment, I would pay half in June and the rest in the next two quarters. This should be a trivial amount based on your previous year's taxes.

Since your taxes were so low last year, you are better off taking advantage of the safe harbor rule than using the Annualized Income Installment Method, which would make your estimated payments much higher in the next two quarters.
posted by JackFlash at 11:56 AM on June 13, 2007