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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 '20 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 '20 at 15:25
  • @Aaron D. Marasco: The instructions say that, but they lie :-( – jamesqf Nov 21 '20 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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Form 2210 is the form which is used to calculate your federal underpayment penalty when you file your income tax return early in the following year. (State underpayment penalties may be calculated differently; I will only talk about federal here.) So the simple answer is that any approach that will result in 0 penalty as calculated on Form 2210 at the end of the year will avoid the penalty.

From your description, it seems you do not have tax withholding from your paycheck, as employees do, so you need to pay estimated taxes. There are two ways to calculate the required minimum level of estimated taxes for each quarter (that needs to be paid by that quarter's estimated tax deadline). The first is that each quarter you have to pay 1/4 of the required estimated taxes for the whole year (since you have no tax withholding, the required estimated taxes for the whole year is 90% of this year's tax or 100%/110% of last year's tax). The second is the Annualized Income Installment Method (calculated on Form 2210 Schedule AI), which allows you to consider the income "so far" up to each quarter, which may help avoid penalty in cases where you unexpectedly got more income in later quarters. You get to use whichever of the two calculations results in a lower penalty.

The Annualized Income Installment Method calculates the amount of estimated tax you are supposed to have paid up to a given quarter based on your income "as you go" up to that quarter, scaled up to the whole year ("annualized"). If you make $30k in the first quarter (which is 3 months), your annualized income for 12 months based on that is $120k, so you calculate your annual tax based on $120k, and then take 22.5% (90% of 1/4) of the tax as the estimated tax you need to have paid up to the first quarter. So in your example, if your tax the whole year based on $120k of income is $12k, then you would have to pay $3k estimated tax the first quarter to be enough for the Annualized Income Installment Method.

You can't just pretend that your income the whole year is going to be your income your first quarter, and calculate the tax based on that, because tax brackets are progressive, so the first bit of income is taxed at lower rates than later bits of income (and the deductions and tax credits effectively make a 0% bracket so the very first bits of income have no tax), so if people could do that then they would pay little or no tax in the beginning of the year, and more tax in later quarters, even if their income is uniform through the year, which would be unfair to the government because they would effectively be giving an interest-free loan to people by allowing them to delay some tax from earlier to later in the year.

If you are pretty sure that the $30k of income will be all your income for the entire year, you could even pay 1/4 of the annual tax for $30k of income, which, if you are saying that $30k of income has $520, means you could just pay $130 per quarter. If you're right that this is all your income for the year, you will end up not having any penalty. Although you won't have paid enough under the annualized income calculation, you would have paid enough based on the 1/4 of the whole year's required payment calculation. However, you are taking a gamble, because if you unexpectedly get income in a later quarter, you would be screwed -- your whole year's tax would increase, which means your payments in previous quarters would no longer reach the 1/4 of whole year's payment level, and you do not have the annualized income calculation to fall back on, so you will have a penalty for earlier quarters.

The only way to guarantee you will not have a penalty regardless of events later in the year, is to pay either 1/4 of the 100%/110% of last year's tax level each quarter, or pay enough each quarter to satisfy the Annualized Income Installment Method based on income up to that quarter.

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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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