I do some freelance work and earned a little over $2,000 in the first three months of this year. I expect I'll make about $200-$300/month for the rest of 2002. Last year (2001), I earned about $2,000 as a freelancer for the entire year, but both my husband and I work at regular jobs, and our withholding taxes were high enough that I didn't owe any additional taxes. In fact, we received a refund.
Do I need to pay estimated taxes for 2002? If so, how do I calculate it since this year's income will be different from last year's? I read what the IRS has to say about form 1040-ES, but I became confused when I read, "Exception. You do not have to pay estimated tax if you were a U.S. Citizen . . . and you had no tax liability for the full 12-month 2001 tax year." Does that mean NOT paying anything at the end of the year to the IRS, or does it mean not paying any kind of taxes at all throughout the year?
Any guidance you can provide will be very greatly appreciated.
-- Carol F, MN
Here's how it works.
As a self-employed person, you have to report your total income and your expenses and pay taxes on your net income (total income minus expenses). The IRS likes to make sure it gets its money in a timely fashion, so they expect individuals who have income from which no taxes have been withheld to estimate the amount they'll owe at the end of the year, and pay one fourth of that amount each quarter. Taxpayers who don't do that have to pay a penalty.
The amount of those estimated payments is based on the amount you and your husband have paid in taxes in previous years. That's the "Total Tax" line on Form 1040 not the balance due line.
As a general rule, to avoid a penalty the total withholdings and estimated tax you pay during 2002 must equal the smaller of:
1. 90% of your total expected tax for 2002, or
2. 100% of the total tax shown on your 2001 return.
There are some exceptions to the general rule. Higher income taxpayers -- those whose adjusted gross income (AGI) for 2001 was more than $150,000 ($75,000 if your filing status for 2002 is married filing a separate return) -- must pay 112% of the 2001 tax or 90% of the expected tax for 2002. (For 2001, AGI is the amount shown on Form 1040 - line 34; Form 1040A - line 20; and Form 1040EZ - line 4.)
Farmers and fishermen can avoid a penalty by paying in the lesser of 2/3 of the 2002 tax due or 100% of the total tax on the 2001 return.
Now, if your withholdings were high enough last year so that you got a refund despite your self-employment, and if you expect your salary and withholding to stay the same, you would not have to make quarterly payments this year.
Keep in mind that even though you can avoid a penalty by making quarterly payments that equal 90% of the tax due this year (or 100 percent of the previous year's tax) , if that amount is less than the taxes due on your income, you still have to pay the balance of the tax when you file your annual return. So, if there is likely to be a big enough difference between last year's income and this year's, be sure you put the money aside so it's available when you file the 2002 return next year.