What Is Advance Tax and Who Is Required to Pay It?
Understand advance tax: its purpose, who must pay, how to calculate and submit payments, and the implications of non-compliance.
Advance tax, also known as estimated tax, is a system for paying income tax throughout the year as income is earned. This aligns with the “pay-as-you-go” principle of the United States tax system. Its purpose is to ensure taxpayers remit tax obligations periodically, preventing a large tax liability from accumulating by the annual tax filing deadline.
Understanding Advance Tax Requirements
Advance tax applies to individuals and entities whose income is not subject to sufficient tax withholding. Individuals, including sole proprietors, partners, and S corporation shareholders, typically need to make estimated tax payments if they anticipate owing at least $1,000 in tax when filing their return. Corporations generally have a lower threshold, needing to make payments if they expect to owe $500 or more.
Many types of income can trigger an advance tax obligation. This frequently includes earnings from self-employment, such as income for independent contractors or freelancers. Other common sources include interest, dividends, capital gains from investments, rental income, lottery winnings, alimony, unemployment compensation, and the taxable portion of Social Security benefits. These may necessitate estimated payments if not adequately covered by other withholding.
Estimating Your Advance Tax Obligation
Calculating your advance tax obligation involves forecasting your financial picture for the entire tax year. A starting point for this estimation often involves reviewing your income, deductions, and credits from the prior tax year, which then needs adjustment for any anticipated changes.
The process begins by estimating your total annual income from all sources, including wages, self-employment earnings, interest, dividends, capital gains, rental income, and any other taxable income. After estimating gross income, account for eligible deductions and tax credits that can reduce your taxable income and overall tax liability. These can include standard or itemized deductions, as well as various tax credits.
Once estimated taxable income is determined, current tax rates are applied to calculate the projected tax liability. From this amount, any tax already paid or expected through withholding is subtracted. The remaining amount represents your estimated advance tax. It is advisable to perform this calculation periodically, such as quarterly, because income, expenses, and deductions can fluctuate, requiring adjustments to your payment amounts.
Making Advance Tax Payments
Once the estimated advance tax amount is determined, payments are typically made in four installments throughout the year. The common due dates for these payments are April 15 for income earned from January 1 to March 31, June 15 for income from April 1 to May 31, September 15 for income from June 1 to August 31, and January 15 of the following year for income from September 1 to December 31. If any of these due dates fall on a weekend or legal holiday, the deadline shifts to the next business day.
Multiple methods are available for remitting these payments to the Internal Revenue Service. Many taxpayers opt for electronic payments due to their convenience and efficiency. Options include IRS Direct Pay, which allows payments directly from a checking or savings account, and the Electronic Federal Tax Payment System (EFTPS), which offers flexibility for scheduling payments in advance. Payments can also be made by debit or credit card through authorized third-party processors, though these typically involve processing fees.
For those who prefer to pay by mail, estimated tax payments can be sent with a payment voucher, such as Form 1040-ES, Estimated Tax for Individuals. This form includes vouchers for each quarterly payment period. When mailing a payment, it is important to include the appropriate voucher and a check or money order, ensuring the envelope is postmarked by the due date.
Consequences of Underpaying or Not Paying
Failing to pay sufficient advance tax can lead to financial repercussions. The Internal Revenue Service may impose an underpayment penalty, typically calculated using Form 2210. This penalty applies if the total tax paid through withholding and estimated payments is less than a certain threshold.
The penalty calculation considers the amount of the underpayment, the period during which the underpayment existed, and the quarterly interest rates set by the IRS for underpayments. This interest accrues on the unpaid amount until it is fully paid. The IRS generally sends a notice to taxpayers who owe this penalty.
Taxpayers can generally avoid an underpayment penalty if they owe less than $1,000 in tax after subtracting their withholdings and credits. Another common threshold for avoiding penalties, known as a safe harbor, is if the amount paid is at least 90% of the tax shown on the current year’s return or 100% of the tax shown on the prior year’s return, whichever amount is smaller. For taxpayers with an adjusted gross income (AGI) exceeding $150,000 in the prior year, the safe harbor based on prior year’s tax generally increases to 110% of that amount.