Estimated taxes are the pay-as-you-go levy on income that escapes withholding. Many unsuspecting taxpayers trigger this liability by selling stock for a taxable capital gain or starting to earn freelance dollars subject to income and self-employment taxes. Most of the public believe they can make up the difference with their tax return, without late payment penalties.
Other income subject to estimated taxes includes dividends, interest, alimony, gambling winnings and children's income reported on the parents' return. Bonuses and stock options may be under withheld. Unemployment compensation, pensions, retirement-account withdrawals and, for some, Social Security benefits may also require estimated tax payments.
Not one penalty, but four? The hidden stinger is that a penalty doesn't depend just on your total tax payments. That is, you must pay the right prorated share of tax for each of four payment periods. Otherwise, you could end up paying enough tax in total and still be penalized for an underpayment.
The payment periods are commonly referred to as "quarters," even though only the first period corresponds to a calendar quarter: Jan. 1 through March 31. The other three periods are April 1 through May 31, June 1 through Aug. 31 and Sept. 1 through Dec. 31. Payments are due 15 days after the end of each period, unless a weekend or holiday delays the due date.
According to IRS statistics, more than 17 million 1992 tax returns reported income solely from sources not subject to tax withholding, yet fewer than 13 million reported estimated-tax payments.
The IRS' own taxpayer advocate recently told Congress that the penalty rules are "extraordinarily complex" and frustrating for taxpayers and "very difficult for the IRS to administer." Many people can avoid estimated taxes by increasing paycheck withholding or by having tax withheld from unemployment compensation or retirement income.
Generally, you must make estimated payments if you expect your tax bill each April to be at least $1,000 and you expect your withholding plus credits to fall below a minimum level. The minimum is either 90% of the tax you will report this year or 100% of your prior tax liability-- whichever is less (110% if your prior year adjusted gross income exceeded $150,000).