Why Make Estimated Tax Payments, Part 2

money-case-163495_1280This is part 2 of an explanation of estimated tax payments. In Part 1, I detailed the math behind the tax formula. In Part 2, I’ll explain why a taxpayer might want to make estimated tax payments.

Here’s the reason: if you’re fully self-employed, you don’t draw a paycheck in the traditional sense.

Since you don’t draw a paycheck, there’s no withholding on your earnings. If we reference the tax formula in Part 1, if your tax liability is larger than your withholdings, estimated tax payments and tax credits, you’ll owe tax when you file your tax return.

If you’re fully self-employed, turned a profit in your business, and paid no estimated tax payments, you’ll likely owe at tax time.

Estimated tax payments aren’t required, but they are highly recommended.

Here’s an example from a real client of mine.

The client is self-employed. He typically owes $25,000-$30,000 when he files his tax return.

He never makes estimated tax payments, and he doesn’t have $30,000 sitting around to send the IRS. So he enters into a payment plan.

Time passes quickly and now it’s tax time again. He owes another $30,000. All of the tax payments he made during the year were applied to last year’s tax debt. So now he’s got another $30,000 debt and another payment plan to work out.

If this process repeats itself too many times, a taxpayer can find themselves hopelessly in the hole.

And that’s why you make estimated tax payments. It forces you to pay your tax liability bit-by-bit during the year, so you don’t end up being saddled at tax time with a tax liability that’s too large to pay in full.