Quarterly Estimated Payments When Income Falls Drastically (US)

Question

I'm self employed and my income tends to be pretty volatile, but every year so far it has increased since I started paying taxes. For example, it increased substantially from 2021 to 2022, so for my quarterly 2022 tax payments, I was able to avoid any penalties for underpaying throughout the year by paying the safe harbor of the amount I owed from the prior tax year. Then I could pay any extra I owed all in April 2023 with no penalties.

However, I expect my income to fall drastically in 2023 (probably a 30% to 50% drop from 2022). So the safe harbor doesn't make sense in this case since I would be way overpaying. However, it's still hard to know exactly how much I'm going to make next year, so even my best estimate could be decently far off what I actually make.

How do you handle quarterly tax payments when you can't use the safe harbor and you don't know how much you're going to make? I'm just trying to avoid any penalties.

I'm in the US.

Answer 1

You'll want to read Publication 505, Tax Withholding and Estimated Tax, Annualized Income Installment Method (page 26 in the PDF). This describes how to figure your tax payment each quarter, and references Form 2210, which has a section to document your income and tax payments each quarter to show that you are paying the appropriate tax.

Answer 2

The amount of taxes you are supposed to have paid in the first n quarters is the least of these three:

1. n/4 * 100% (or 110% for high earners) of last year's tax liability
2. n/4 * 90% of this year's tax liability
3. n/4 * 90% of the annualized income based on the income in the first n quarters of this year

You don't want to do option 1 because it will pay way too much. You can't predict the future so option 2 is risky. So the only option that is safe and doesn't pay way too much is the Annualized Income Installment Method. This means that you have to basically do 4 separate "tax returns", one after the end of each quarter, to figure out how much in estimated taxes you need to pay. You will need to complete Form 2210 Schedule AI when you file your tax return.