The third estimated tax payment is due on September 15th. There's always lots of questions about how to figure out the right amount of estimated tax to pay, and one common situation is figuring out how to estimate taxes on a side job when you work full time.
This is a fairly common situation, especially as people start moonlighting to supplement their paycheck. One reader asked,
"I have a question about estimated taxes. I need to pay Federal and State estimated taxes for some freelance work, but I didnít send a voucher in April or June. I was planning to catch up in September, but now see in the state tax instructions that I should start in April. If I send an estimated voucher and check now, what happens?"
There's several options available to cover the tax bill associated with this extra freelance income. You can make estimated payments, due four times a year, based on this extra income. Or you can adjust your tax withholding at your regular job to have more taxes taken out. There's pros and cons of each approach. For someone who needs to catch up on earlier estimated payments, it might be better to adjust your withholding, as I'll explain below.
First, let's review briefly about estimated payments. These are required when you have extra income, such as from freelancing, rental income or investment income on which no taxes are automatically withheld. The IRS will add a penalty for underpaying your federal taxes if you owe more than $1,000. So one tax planning tip is to make sure your paying in enough to avoid this penalty. This penalty is basically an interest charge for paying the IRS late. Currently, the IRS interest rate on underpayments is 4%. (You can see a chart of all the IRS interest rates historically at the TaxAlmanac Web site.) This penalty can be avoided as long as your total payments to the IRS (withholding plus estimated payments) are the lower of either 90% of this year's tax (2009) or 100% of last year's tax (2008).
So you'll want to figure out how much extra tax you'll need to pay in from your side job. I provide some tips in this sample calculation of estimated tax. The easiest calculation is to use your marginal tax bracket for 2009, and add in the 15.3% self-employment tax. This calculation actually overestimates your taxes, but it's a good place to start if you want to keep the math simple.
Next, you'll want to decide whether to pay this in quarterly by making an estimated payment, or adjust your withholding to have extra taken out of your regular paycheck. Here's where a little known trick can help you save on this underpayment penalty I mentioned earlier. Let's say the extra tax you owe, just to make up a number, is $1,234. Now if you make an estimated payment, you would pay in the first three payments by the September 15th deadline, or $926 (three-fourths of the extra tax amount). This will get you "caught up" with your estimated payments. But the IRS would likely see this as underpaying for the first two quarters, and assess an interest penalty when you go to file your return.
There's two ways around this interest penalty. First, is to use the annualized method of calculating your underpayment penalty. This is discussed in detail in the Instructions for Form 2210, in the section on annualized income. This method works best if your freelance income occurred only during part of the year. The second method is to adjust your withholding. Withholding from a paycheck is considered by the IRS to be evenly withheld throughout the year, thus avoiding the presumption on the part of the IRS that a penalty might apply. To adjust your withholding, fill out a new Form W-4, leave your withholding allowances the same as your old W-4, and on Line 6 indicate how much extra you want withheld from each paycheck. To further our example from above, if you need to pay in an extra $1,234, and you have six pay periods left in the year, then you would need to have an extra $206 deducted from your paycheck.
If you want to calculate your estimated tax payments more precisely, use the worksheet found in the package for Form 1040-ES.