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ESTIMATED TAX PAYMENTS - The Penalty
Trap
If you have received income and tax hasn't been
withheld, there is a good chance you should be making estimated tax payments
or risk owing underpayment penalties.
The examples listed below are the types of income that often can
require the need for estimated tax payments:
- Self-employment income (1099
income)
- Dividend and interest income
- Gains from stocks or real property
As is usually the case most tax related rules are hard to understand
and the rules for making estimated payments are no
exception.
To avoid underpayment payment penalties, you must
have the following percentage of tax paid in equal installments each quarter (in most cases):
- 90% of the total
tax you will owe in the current tax year.
- 100% of of the tax owed in the prior year (110% if
your prior year's adjusted gross income exceeded
$150,000).
I have listed the very basics above to keep it
simple. There are many factors to consider
such as whether income has substantially risen or
decreased in the prior year or if a larger portion
of your income was incurred at one time.
The form used to make estimated payments to the IRS is 1040-ES. The state of California is 540-ES. Please note California's rules are different from the IRS.
The penalty for underpayment is the IRS interest rate which changes quarterly and is 7% for the fourth quarter of 2005.
If you are not comfortable calculating your estimated tax payments, typically the cost of paying a
professional to calculate the correct tax is less
than the penalties involved so it makes financial
sense to get the help if you need it.
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