Why Make Estimated Tax Payments, Part 1

dollar-499478_1280This is part 1 of 2 parts on estimated tax payments.

People who are new to self-employment are often confused about what estimated tax payments are and why they might need to make these payments.

To understand estimated tax payments, you need to understand how taxes work. I’ve written about this before, but I’ll recap again here.

Most people are conditioned to believe that tax time = refund time. But most people don’t understand why they get a refund.

Contrary to popular belief (and contrary to the H & R Block commercials), tax refunds are not a magical creation.

Let’s look at the basic income tax formula*

*-A note for the tax pros and other readers who are sticklers for details: this formula is highly simplified and leaves out certain things such as self-employment tax and alternative minimum tax on purpose

  1. Start with your income (if you’re self-employed, this would include your net income from self-employment)
  2. Subtract out certain deductions for things such as student loan interest
  3. Subtract out your standard deduction or itemized deductions
  4. Subtract out your personal exemptions
  5. You’re left with taxable income
  6. A certain amount of tax is owed on your taxable income

What?!?! I always get a refund at tax time! How can you say “a certain amount of tax is owed” when I always get a refund???

Stay with me:

  1. From your tax owed, you subtract any credits you qualify for and any payments you made through paycheck withholdings and estimated tax payments
  2. If the total of your credits, withholdings and estimated tax payments is more than the amount of tax owed in #6 above, you get a refund. If your credits, withholdings and estimated tax payments are less than the amount of tax owed in #6 above, you’ll owe additional taxes when you file your return.

In part 2, we’ll examine how this formula plays into estimated tax payments.