We are each required to pay taxes to the IRS.  If you are an employee your employer withholds taxes from each paycheck and sends the money to the government.  This allows your taxes to be paid “as you go” and usually results in a nice refund after you file your return. If you are self employed or have additional income other than your paycheck from an employer, you still need to pay “as you go”.

If you are an employee and you claim too many exemptions which leads to not enough money deducted from your check, you could be hit with an underpayment penalty by the IRS.  You will be notified by a bill in the mail from the IRS.  This penalty is actually interest on the taxes you did not pay.  You will then be responsible for paying the additional taxes, the interest and you could be hit with additional penalties for if you don’t act swiftly upon receipt of the IRS bill!

If you are self employed you are expected to pay your taxes quarterly.  These are estimated taxes and are required every quarter.  You owe estimated taxes if you have income from anything on this list:

• Dividends
• Sales of stocks or assets that qualify as gains
• Income from Interest
• Earnings from a business
• Alimony

When you file your tax returns, if you have not paid enough estimated tax each quarter, you will be hit with tax underpayment penalties.  These tax underpayment penalties apply to each quarter, so even if you paid enough estimated tax in three of the quarters and underpaid during the first quarter, you will be penalized for that individual quarter.  The penalty is in the form of the going interest rate.  It will be applied from the date the underpayment occurred until the time in which it is paid in full.

For example, you determine that you will need to pay $10,000 in taxes this year.  You should break this into 4 equal payments to send to the IRS each quarter.  However, let’s say that you didn’t make the first quarter’s payment of $2,500 but you did make the 2nd 3rd and 4th quarter’s payments and you paid $5,000 on your 2nd installment to make up for missing the first quarter’s payment.  You may still be hit with tax underpayment penalties for not having made the first quarter’s payment on time.  Even though you did in fact pay $10,000 for the year, you did not pay it quarterly as is required.  Therefore you will have to pay interest on the $2,500 from the actual date the first quarter’s payment was due!

The best way to avoid being hit with tax underpayment penalties is to contact a tax professional and make sure you are paying the right amount each and every quarter! The IRS does have Form 1040-ES to help you calculate how much you should pay each quarter but it is a very complicated form and most say a tax professional is needed to work through it.