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If you have a steady income you pay taxes continuously based on the assumption of the final income per year. However if your income is very spikey you may have no idea how much you will be making in a given year. You still have to pay estimated taxes to avoid a penalty but how do you estimate?

I was wondering if the following approach will avoid the penalty: pay estimated taxes every time you generate income under the assumption that there will be no more income for the rest of the year. An example: let's say you make $120k/year. Tax would be around 12k (married, jointly). If you are on a salary you would simply pay 3k per quarter.

Now if you are a freelancer and make 30k in the first quarter but have no clue how the rest of the year will look like, how much estimated taxes do you need to pay? If 30k is your only income, you would only have to pay $520. If you keep making 30k/quarter, you would pay 3.3k in Q2 3.6k in Q3 and 4.3k in Q4 for a total of 12K. If you make nothing in Q2 and Q3 and 90k in Q4 you'd pay nothing in Q2 and Q3 and 11.5k in Q4. It's still the same total but it's paid less early in the year and more later in the year. It's paid when the income happens.

In the scenario described I would have paid $520 in Q1 and not $3000 that I should have paid. Question: Would that incur an underpayment penalty ?

Assumptions:

  • I can not pay 110%/100% of last years taxes since that would be a gross overpayment
  • I DO pay 100% of this year's taxes. The question is not about the total amount but about the sequencing and timing of the payments.
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    The IRS implies that 1040-ES instructions tell you how to estimate without being penalized. – Aaron D. Marasco Nov 21 at 14:23
  • One random point. Note that quite a few people just say " **** You " to estimated taxes, and, simply pay it all at once on tax day of the next year. Of course, there's a penalty of a grand or two for doing so. (As an aside, one can fairly often get out of that with a bit of complaining.) But for many struggling with the usual pains of small business, it's worth it for the advantages (notably "keeping your money in hand" :/ ) – Fattie Nov 21 at 15:25
  • @Aaron D. Marasco: The instructions say that, but they lie :-( – jamesqf Nov 21 at 16:24
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There are enough freelance workers that the IRS has a policy for this situation: the annualized installment method.

The purpose of this worksheet is to determine your estimated tax liability as your income accumulates throughout the year, rather than dividing your entire year's estimated tax liability by four as if your income was earned equally throughout the year. The top of the worksheet shows the dates for each payment period. The periods build; that is, each period includes all previous periods. After the end of each payment period, complete the corresponding worksheet column to figure the payment due for that period.

This Investopedia article explains it, but it doesn't seem to exactly fit your situation. Better speak to a tax accountant.

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Now if you are a freelancer and make 30k in the first quarter but have no clue how the rest of the year will look like, how much estimated taxes do you need to pay?

Unfortunately, I'm pretty sure the answer is dead simple: you pay it exactly as if your income will continue like that (ie, 120 basis).

That's all there is to it.

(Sure, you may lose clients, the world may end, you may triple your clients, whatever. Estimated is estimated, you just do it on an annualized basis.)

Unfortunately.

Note you're saying you have "no clue" - in that case the only rational estimate is "120" (what else could it be, unfortunately?)

(If you do in fact know that annual income, will be 30, that's not the same as "no clue". For the typical freelancer, it's "no clue".)

The reality on the ground is every freelancer does the "assume 120" method - unfortunately. Which seems to be the sense of the question.

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