Is There A Penalty For Overpayment Of Estimated Taxes For Self-Employed Taxpayers?

9

Min Read

Maria Malyk

Paying income taxes every year is something required by the Internal Revenue Service of anyone with an income, but it's not exactly a quick, easy or straightforward process, is it?

Getting a handle on paying taxes is particularly challenging for self-employed workers who are responsible for doing their professional work and running every aspect of their business, including keeping ongoing track of all the necessary tax documentation, doing the math accurately, and filing all the paperwork, etc.

And that includes handling one of the more cumbersome accounting chores: making estimated tax payments every quarter -- with the correct amounts and by the deadline, to avoid penalties from the IRS. If that sounds like a lot of work and you are not an expert on accounting, you can:

  • hire an accountant
  • learn how to do all the calculations yourself through old-fashioned bookkeeping
  • employ the help of a smart 1099 expense tracker app like Bonsai Tax, that will calculate reasonably estimated tax payments for each quarter, help you file your tax return due on April 15 of every year -- and take the bulk of the rest of accounting/bookkeeping tasks off your shoulders.

If you are unsure of how to properly anticipate quarterly tax payments to the Internal Revenue Service as a 1099 self-employed worker, read on for some simple explanations  -- and to learn how to de-complicate and streamline your business finances with the Bonsai Tax accounting software designed specifically for you and your freelancer needs.

The American "Pay-As-You-Go" Taxation System

Let's start by taking a moment to understand the principle behind how U.S. taxes are paid.

The IRS subscribes to the "pay-as-you-go" taxation approach, whereby taxpayers need to pay a certain number of percent in taxes to the IRS on all income -- on an ongoing basis.

Differentiating Income Tax Payment  Between W-2 Employees And 1099 Workers

All Americans pay income tax, but the way it's done varies depending on the taxpayer's employment type/status.

W-2 Employee Tax Responsibilities

Taxpayers working for someone else (as opposed to themselves) are considered "W-2 typical salary employees". Those employees have taxes automatically withheld from each paycheck they receive from the company that issues them. Those employees fill out a W-4 form at the beginning of the year, indicating what percent of tax is to be withheld on their behalf (as of 2020, Form W-4 has been redesigned for an easier way to calculate the appropriate amount of withholding allowances -- and it is easier to follow and fill out).

Self-Employed Workers' Tax Responsibilities

Self-employed freelancers/contractors (a.k.a. "1099 workers"), on the other hand, need to make their own arrangements for paying taxes to the IRS -- and to do so on a regular basis. For freelancers who typically have multiple clients and work on differently-sized projects, income does not come in uniform sums of money, or from the same origins, or on the same schedule as others.

This is why it is imperative for independent contractors to keep meticulous track of their finances: because if they don't keep good records of income -- as well as business expenses to write off in order to lower the income tax to pay to the IRS-- they will leak money from their business and likely incur IRS penalties for not reporting income properly, underpaying (or defaulting on) quarterly taxes, missing the payment deadline, etc.

The Bonsai Tax app can help you wrestle the whole process under control -- and spare you all the complex calculations of quarterly tax estimates and pretty much all other accounting math associated with your business. Just answer some questions, enroll some data, scan some receipts -- and the rest is organized, calculated, filled out, and processed by the software.

Quarterly Estimated Tax Payments: How Freelancers Pay Taxes

As it would be supremely complicated to send in tax payments on each individual transaction that brings income to the freelance taxpayer, the IRS instead expects a "quarterly" installment to be made every three months, each by a specific deadline. It is preferable that the quarterly payments are equal in value to each other within the same year (but if a taxpayer finds that their income fluctuates wildly between quarters, they must alert the IRS by filing form 2210 along with the annual tax return).

Quarterly estimated taxes are mandatory and must be paid by any freelancer owing more than $1000 from their earnings per given tax year.

Quarterly Taxes Paid By Self-Employed Workers

1099 Workers typically pay two types of tax:

  • Income Tax. This includes federal tax for all Americans and state tax for those who live in U.S. states with state taxes.
  • Self-Employment Tax. This tax serves as the Social Security and Medicare tax for the self-employed.

Determining The Estimated Tax Payments

In order to estimate taxes to pay each quarter of the coming year, you have to have an idea of the income you expect to earn.

The most popular way to estimate the coming year's income is to base it on previous year's total income.

Next, look up that income in the IRS marginal tax bracket: it will give you the percentage of your income you have to pay.

Next, you calculate your income and self-employment tax liability for the whole year using the following formulas (2021):

  • Income Tax: your Adjusted Gross Income x Tax Rate
  • Self-Employment Tax: (Your Total Income x 92.35) x 15.3

Once you calculate the tax liability for the year, you split it into four: and now you have your quarterly estimated tax payments.

Alternatively, this would be a great time to bring abroad the Bonsai accounting software to calculate quarterly federal/state income tax and self-employment tax estimates for you under its famous 100% accuracy guarantee...

When Are Quarterly Estimated Taxes Paid?

When are quarterly taxes due? Quarterly tax due dates for the 2021 tax year are as follows (except for when a due date falls on a weekend or holiday, in which case the payment is due the following business day):

  • January 1 to March 31: file by April 15, 2021
  • April 1 to May 31: file by June 15, 2021
  • June 1 to August 31: file by September 15, 2021
  • September 1 to December 31: file by January 18, 2022 (note: if you file your 2021 taxes by January 31, 2022, and pay the entire balance due with your tax return, you don't need to pay this fourth installment)

Keep in mind that your minimum quarterly payments to keep from getting fined are cumulative. This means that if you paid enough for two quarters during your first-quarter payment, you can skip sending in the payment when quarter number two rolls around.

Where To Make Your Estimated Tax Payments

Estimated tax payments to the IRS are can be made in a variety of ways, the most popular of which are:

Underpayment Vs. Overpayment of Estimated Taxes

Let's be clear: overpayment of taxes is in every way preferable to underpayment of taxes! The former is what the IRS expects -- and any money overpaid will be refunded eventually. The latter is against the IRS rules and will result in a penalty.

Ideally, you should strike a balance in which you overpay quarterly taxes somewhat -- but just enough to stay on the safe side of covering what you may owe and avoid a penalty (i.e. just enough that you are sure you won't accidentally underpay).

So, what is the "sweet spot" of a tax estimate?

How Much To Budget For Estimated Tax Liability?

The convention is to set aside 30%-35% of each paycheck / earning for estimated payments.

What Is The Penalty For Underpaying Estimated Tax?

The underpayment tax penalty can be calculated by using Form 2210.

The penalty calculation is based on:

  • The amount of the underpayment
  • The duration of the time when the payment was due and underpaid
  • The interest rate for underpayments that applies to a given quarter

You can let the IRS calculate the underpayment penalty for you if your case falls under the following criteria:

  • You did not put aside enough tax by the year's end
  • You are not eligible for any exceptions
  • You did not file a Form 2210

How Soon Are Taxpayers Penalized For Underpaying Estimated Taxes?

The IRS does not pay attention to the taxpayers' quarterly payments of the prior year until the tax return is filed (Schedule C, Form 1040) the following year. At that point, they figure out your total tax due on the basis of the income you made over the year and cross-reference it against the quarterly payments. If the tax liability for the year had not been covered, the IRS notifies the taxpayer of the problem via a letter in the mail.

What Is The Penalty For Overpaying Estimated Tax?

There is no penalty by the IRS for overpaying taxes.

Keep in mind, however, that, while the IRS collects interest on underpaid taxes, it does not pay interest on whatever amount you overpaid. Therefore, you might not want to put extra thousands upon thousands of dollars into the hands of a government agency for months without you getting anything out of it!

That money could be put to work for you or your business instead! For example, you could use it to pay off a credit card debt that would otherwise continue accruing interest.

In short: avoid overpaying too much estimated taxes as that money can do more for you when it's in your own pocket.

How Soon Can I Expect To Be Refunded Overpaid Taxes For The Year?

The taxpayer has a choice to have their overpayment refunded -- or have it applied to the following year's estimated tax payment.

Tax overpayment refunds are released six-to-eight weeks from the date the IRS receives your tax return (assuming it is complete and without errors).

If you choose that your IRS overpayment is applied to next year's taxes, it will be applied to the first installment of estimated payments of the following year.

It's OK To Need A Little Help With Taxes

The last thing any business owner needs is the shock of being hit with a bill for outstanding tax liability they were unaware of --with interest and underpayment penalties tacked on good measure!

The best way to avoid such unwelcome surprises is to employ the help of a reliable digital accounting toolkit that gets things done and keeps you in control and on schedule.

Let Bonsai Tax Estimate Your Quarterly Income Tax Payments And Handle Other Accounting Needs

Freelancers thrive most when they work smarter, not harder (actually, this is true for everyone!)

The Bonsai Tax app allows for exactly that: to focus on the professional work you do best -- that no one can do but you -- and to leave the accounting, bookkeeping, number-crunching, and form-filling to an intelligent tool designed for this very purpose. The Bonsai Tax app will:

  • Track your income
  • Scan/organize your business expense receipts for maximum deductions
  • Auto-import your credit card/bank data in real-time
  • Calculate estimated tax payments every quarter
  • Issue "profit & loss" financial reports to keep you on-budget
  • Auto-fill/help to file your tax return
  • Take care of all of your freelancer accounting needs -- all in a safe, secure, super-easy-to-use, cloud-based online account, accessible from Mac, PC, iOS, and Android devices

Sign up for our free trial and experience the extraordinary utility value and the peace of mind you get with having Bonsai Tax on your side.

Maria Malyk
Maria is a freelance copywriter and language translator, with a PhD in sociology of culture and cognition and a background in academic, legal and financial writing. A digital nomad, Maria also keeps a travel blog while working on a guidebook for solo travelers on a budget.

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