What Are Estimated Taxes & How Do We Prep For Them?
Estimated taxes are spoken about often, but what are they and how should you prepare for them in your private practice? Check out the video above, or, read the transcript below so you can be prepared this year!
What are Estimated Taxes & Why Do We Pay Them?
Hey, it’s Nate from Navigator Bookkeeping and I’m talking today about estimated taxes. It’s that time of year where your accountant has probably come to you and said, Hey, time to pay up and you’ve paid your year end tax bill, but then you’ve also paid estimates and estimates to me when I talk to practice owners are one of those things that many practice owners are just not clear run, and that’s not a fault of their own, it’s a fault of usually CPAs telling them, this is what you owe, but not really explaining what estimates are.
So let’s do a quick, I don’t wanna call it a deep dive. We’re gonna do a quick medium dive on what estimates are and what you need to know about them. So first things first, what are they? So estimates, quarterly estimated payments, you hear them called quarterlies estimates, all those things.
It’s basically, you paying your taxes throughout the year. The IRS and the state that you live in operate on a pay as you go system, which means that they want to get their money from you throughout the year instead of all at once at the end of the year, once the year is finished.
When Do We Pay Estimated Taxes?
So we have these deadlines throughout the year when we pay quarterly taxes. Now those deadlines a little confusingly are not equally spaced out. There are four of them in each year, but they’re not equally spaced out by three month periods or anything like that. So the dates usually are, sometimes this shifts because of calendar conflicts or weekends, but, usually 4/15, 6/15, 9/15, and then 1/15. So the first two are pretty close together. April and June. Then you have a nice break until September and then you have a really long break from September to January.
Now in those payments, those are all paying for the current year except for January. That’s paying for the year that just finished. So April, June and September are all paying for the current year you’re in. So we’re in 2024. Those all would be paid in for 2024. And then when we pay in January of 2025, that’s actually the last payment for 2024. So confused yet? Hopefully not.
But that’s kind of the schedule there. So basically you’re just paying in throughout the year. Now these quarterlies are for your personal income tax. So this is something that is required of most businesses, but the kind of confusing part is it’s actually your personal income tax liability that you’re paying in for these estimated taxes instead of anything for the business.
That being said, it’s closely tied to the business. Because if you’re a business owner like me, and if you’re watching this, you’re probably a business owner, the profits from the business are most of your income.
So profits that the business generates become a tax liability for you, which you then have to pay to the state and the federal government, maybe even the local government depending on where you live. So that’s what estimated taxes are.
Now as far as whether they’re necessary, the IRS does assess a penalty on you if you don’t pay them. I’ve heard tales of those, penalties being pretty small, like 50 bucks, 10 bucks and I’ve heard, a couple $100, depending on how big of a company you are, how much tax you have, those penalties could be big. But in my mind, let’s just pay the IRS what they’re asking us to pay.
So we don’t have any scrutiny towards us. So there’s no bad marks in our file saying, Hey, these people aren’t paying estimates. Let’s just pay them because that is what the law is saying.
That’s what estimates are. That’s how we pay them. You can pay them online, you can send in a check, but let’s talk about how much you need to pay and where that calculation comes from. ‘Cause this is where when I’m talking to clients, we see the most confusion.
How Are Estimates Calculated?
We might hear an amount told to them by their CPA, like, you owe $5,000, but where is that coming from? So there’s a couple areas. Estimated taxes are usually based off your previous year’s tax liability. So for example, if in 2023, you owed $20,000 in taxes, your CPA could then just take that $20,000 and have you pay that split into four payments, in 2024.
So you pay $5,000 per quarter to get to a total of $20,000. So you’re basically paying what you paid last year to cover this year’s tax liability. ‘Cause they’re projecting out what’s your tax gonna look like. So that’s usually how that’s calculated. It’s based on last year’s profit, but really what’s driving that number, how much you could pay or are gonna pay is this year’s performance.
So if we had $20,000 in, tax liability last year, but this year our business is growing, there’s tons of profit flowing in, you’re probably gonna owe a lot more this year. So you actually could pay more into those estimates. Now here’s a little bit of a wrinkle. You may have heard a term called safe harbor. There’s a safe harbor rule when it comes down to estimates and that determines how much do you have to pay.
What’s the minimum you have to pay? You always can pay more. The IRS in the state are never gonna say, no thank you. We don’t want your money. But there’s a safe harbor rule that determines what’s the smallest amount I can pay without getting penalized.
Safe Harbor Rule?
And that safe harbor rule oftentimes is based off of last year’s payment. So in my example, I said, let’s say last year you owed $20,000 in tax. What we’d say then is you need to pay a 100% of last year’s tax liability to be in the safe harbor rule. Meaning that if you pay that, even if your business skyrocketed and profit was very different, you still would not get penalized for that.
Depending on your income level, that could be 110% of last year’s profit, but it’s either gonna be a 100 or 110% of last year’s tax.
So if we owed $20,000 last year, we’d have to pay $20,000 this year to not be penalized or 110% of that if we are in a higher tax bracket. The other way you can think about it is you have to pay, you can do either or of these. I think you have to pay the smaller of these two is how it’s written, but you can do 90% of this year’s current tax liability.
So, that’s a little bit harder, ’cause in the year we don’t know what our tax liability is gonna be. We know last year’s was 20,000. We can look at our tax return and see that, but we are in the middle of this year running our business. We’re not, we don’t know what our tax liability is gonna look like, but at the end of the year, once the year is finished, if you’ve paid 90% or more of the current years, that also will not be a penalty.
So two ways to look at that, to think about that. So that’s a safe harbor rule and that’s usually how your accountant is gonna figure things. They’re gonna say, what was your tax last year? Let’s pay that amount. And then if you think the business is really gonna be dramatically increasing, let’s pay some more into that just to get ahead of it.
So when we get to the end of the year, we don’t have a huge tax bill. Now a couple things to think about. Lots of times what will happen with business owners is the accountant will give them those estimate numbers and say, here’s your four quarterly payments, pay these to the state and to the IRS, you’re good to go. But then that’s kind of the end of the conversation. We don’t have any continuation of that conversation and that’s where I think we have a, mismatch here of we’re missing what’s happening.
We’re missing the advantage of talking to that tax preparer throughout the year. What you really should do is you should check in with your tax preparer throughout the year, depending on if your business is changing compared to last year.
So if last year we had a $100,000 in profit and this year so far we’re three months through the year and we already have a $100,000 in profit, you should probably check in with that accountant and say, Hey, just so growth is much different this year. And that can go up or down. Because let’s say last year you had a $100,000 in profit, but this year after three months you have $5,000 in profit. You might be sending the account, Hey, business is actually pretty slow this year. Do I need to pay this much in my estimates?
And that’s where that 90% rule for this year, a 100% for last year comes in. Because if this year is a lot slower than last year, you can afford to pay less in your estimates as long as you’re still at that 90% benchmark of 90% of this year’s tax liability.
But that’s not something you wanna try to figure out on your own. That’s something you wanna be talking to your tax preparer about throughout the year to check in on. So if you have any big changes in the business, if the business is drastically growing, if it’s drastically shrinking, talk to your tax preparer and figure out, hey, can I either pay more or less into these estimates throughout the year so I’m in a better position when we get to year end? So just that’s hopefully a helpful explainer, some helpful context.
I know when I talk to a lot of business owners, they’re curious, what are estimates? How do I find those? What is this magical number I’m being given? That’s where it’s all coming from. It’s coming from last year’s profit and tax liability usually, and this year’s estimates are based off your business growth. So keep that communication open with your tax preparer.
Talk to them at least once or twice throughout the year. If things are changing drastically in the business, you can change those estimates as needed and, make sure you pay those on time. I know that April one is a hard one because you’re paying usually year end taxes for the previous year plus your first quarters. There’s a lot going on with that.
How To Prepare for Estimated Taxes
But if you’re having a hard time paying your taxes, check out one of our other videos about your tax savings account and profit first and how that can help in setting some money aside throughout the year to cover your tax liability. I know for me, it’s a game changer for many of our clients, is a game changer because we get to that 4/15 time period when all those taxes are due and we’re just drawing right from that tax account.
The businesses paying that money for us, and we’re not having to scramble personally to pay you that money. So, if you’re getting that tax stress, that tax anxiety that comes up in April sometimes or in March when you see that big tax bill or it’s really surprising, you’re like, wow, I didn’t expect this. Nobody told me this. Don’t feel any shame or guilt in that. That happens.
Sometimes we have tax preparers that are not as high quality as we want them to be, who are maybe just not as proactive as we want them to be. But one way you can mitigate that is set aside money every month into that tax savings account. Set it aside, prepare it for the future and talk to someone who can help you set up some of those profit first allocations so that every month you’re setting aside a percentage of revenue into that tax savings account that can pay those estimates per for you pay those year end taxes for you.
If you have any questions about estimated taxes or the tax savings account, leave a comment below this video. Happy to chat more there and we’ll talk soon.