Although April 15 is the annual filing deadline for individuals, taxes are actually due throughout the year. The IRS requires taxpayers to pay federal taxes as they receive income. If you receive especially large capital gains during the year, use IRS Form 1040-ES to determine whether you need to make an estimated payment and the size of the estimated payment.
What Are Capital Gains Taxes?
The IRS assesses taxes on the sale of capital assets such as stocks or real estate based on the difference between a sale price against the purchase price or basis value. If there is a loss, it is known as capital loss and it may be treated as a tax deduction within certain parameters. However, if the amount of sale is more than the basis it is taxed as a capital gain.
The tax on capital gains is determined by the length of time the asset was held before the sale. If the asset was held for less than a year, then it is a short-term capital gain and it will be taxed at a higher rate than an asset held for over a year for a long-term capital gain. In general, both long and short-term capital gains are lower than the rates on income. The typical capital gains tax rate is not higher than 15 percent for most people.
Read More: How to Calculate Capital Gains Taxes
What Can Happen if Taxes are Underpaid?
When you earn wages from employment, your employer automatically withholds federal and state taxes from each paycheck to cover your tax liability. Often, that is adequate to cover most of the tax liability owed by a taxpayer, but not always. However, other forms of income -- like capital gains, dividends and self-employment income -- don't have automatic withholding. If you have substantial income from these sources and don't withhold enough in taxes, the IRS can penalize you for underpaying your taxes during the year.
Underpayments may be assessed penalties for late payments by the IRS if you will owe over $1,000 and have not withheld at least 90 percent of your tax liability for the year. The IRS will calculate penalty amounts based on quarters of the year. The IRS will look at how much tax was underpaid and assess a penalty for each underpaid quarter of the tax year. The amount of penalty from each quarter is then added up at the end of the year and owed with your taxes.
Even if your total income for the year comes from W-2 wages, that does not grant you immunity from underpayment penalties. Penalties may be incurred if you are not withholding enough taxes on your wages. It is generally a good idea to review your W-4 each year, especially if you experience a life change, to make sure your wage withholdings are adequate.
Read More: How to Calculate Capital Gains Taxes
Who Must Make Estimated Tax Payments?
Making estimated tax payments allows you to avoid underpayment penalties. The IRS requires taxpayers to make estimated tax payments if both of the following scenarios apply:
- You believe you'll owe more than $1,000 in taxes at the end of the year after tax withholdings and credits are applied.
- You believe your tax withholdings and credits will be less than 90 percent of this year's tax or 100 percent of your prior year's tax, whichever is smaller.
For example, say that you owed $40,000 in taxes this year, expect to owe $40,000 in taxes this year and estimate your current year withholdings and credits to be $30,000. $30,000 is less than 90 percent of $40,000, and you expect you'll owe $10,000 in taxes – $40,000 less $30,000 of withholdings and credits – so you must make estimated tax payments.
Estimated tax payments are typically based on the prior year's numbers since the income for many people often does not fluctuate much from year to year. However, that is not always the case. Sometimes, a person will start a business or maybe sell inherited assets and owe capital gains which will change their tax situation for that year. In these cases, it is wise to consult with a tax professional to get an idea of how much you may owe each quarter.
Another alternative is to overestimate your payments until you have a clearer idea of how much you should be paying each year. The amount of overpayment will be returned after you file your taxes.
How to Determine Your Payment
Complete the IRS Estimated Tax Worksheet in Form 1040-ES to calculate the size and frequency of your estimated tax payments. There are four estimated tax payment deadlines during the year. The first-, second-, third- and fourth-quarter deadlines are April 15, June 15, September 15, and January 15, respectively, unless the deadline falls on a weekend or national holiday, in which case the deadline falls on the first non-holiday weekday following the standard date.
Estimated tax payments should be made in the quarter in which you receive the capital gains. For example, if you receive all the capital gains on May 31, make your estimated tax payment on June 15. If you receive the capital gain distribution evenly throughout the year, you need to make four payments. Be sure to take into consideration your filing status and other elements such as capital losses.
In many cases, capital losses can offset the amount of capital gains, this is known as tax-loss harvesting. Be aware there are rules regarding tax-loss harvesting that can nullify their value such as the rules on wash sales of securities.
If you find yourself making estimated payments to the IRS then you may also need to make estimated tax payments to the state. Many people forget about state taxes when planning quarterly estimated tax payments. Make sure that you also know what the state will expect as well as federal.
How Can Estimated Payments Be Made?
The IRS allows taxpayers to make estimated tax payments via phone, check, money order, credit cards, debit cards, bank account transfer and wire transfer. If you make the payment by mail, include the voucher from your completed Form 1040-ES. If you'd prefer to pay online, visit the IRS Electronic Payment Options website for a list of service providers. Check with your state tax board to find out if or how you should be making estimated payments at the state level.
You can usually have vouchers for the following year printed for you from your tax professional when you file for the current year. These vouchers can easily be mailed with a check to the correct tax authority. This is a helpful option because there are a few different ways their tax software can calculate the quarterly amounts to be paid based on your income history and other factors.
Based in San Diego, Calif., Madison Garcia is a writer specializing in business topics. Garcia received her Master of Science in accountancy from San Diego State University.