Estimated taxes aren’t a separate liability but rather a way of paying taxes throughout the year in four installments. The third estimated tax payment for 2017 was due no later than September 15, 2017, and the fourth payment for 2017 is due on January 16, 2018 (for hurricane victims, the third and fourth payments are due by January 31, 2018).

If your annual federal tax bill isn’t covered by withholding and you don’t qualify for certain safe harbors, you face tax penalties on underpayments of estimated tax.

Here’s why you need to address estimated taxes—determining whether and how much to pay—and 3 steps for being estimated tax compliant.

Background

Federal income taxes are a pay-as-you-go system, with the bulk of taxes paid through withholding on wages. There are also a variety of voluntary and mandatory withholding on payments such as Social Security benefits and retirement plan distributions. If you owe taxes and can’t pay them through withholding, you usually have to do so through estimated taxes.

It was reported by the Wall Street Journal that the number of individuals underpaying estimated taxes (and penalized) has risen by nearly 40% between 2010 and 2015. There are a couple theories for this sharp increase:

• Penalties have been low. The estimated tax penalty is pegged to the IRS interest rate for noncorporate underpayments, which has been relatively low. From October 1, 2011, through March 31, 2016, the rate was only 3%. The rate has been 4% since then (it adjusts again on October 1, 2017, and could increase at that time). Because of the low rate, some have opted to delay payment until they file their return, figuring that the penalty cost isn’t a big deal.
• There’s been growth in the gig economy. Those working through Uber, TaskRabbit, and other online platforms are not subject to withholding on their earnings. Nonemployee compensation must be paid through estimated taxes in most cases (see payment suggestions below). Many gig workers have been unaware of the need to make estimated tax payments (and may have overlooked payments for self-employment tax on their earnings).

The Treasury Inspector General for Tax Administration found that with respect to those in Puerto Rico (where there is no federal income tax on earnings) the IRS failed to assess $112 million in unidentified self-employment taxes and $172 million in underreported self-employment taxes over 5 year. Self-employment tax on net earnings is paid through estimated taxes in the same way that federal income tax on these earnings is paid.

What these numbers tell me is that the IRS will be trying harder to check on estimated tax payments. (Earlier this year the IRS set up a Sharing Economy Tax Center to inform gig workers of their tax obligations.) And in a rising interest rate environment it’s going to be more costly for those to neglect this payment obligation.

3-steps for being estimated tax compliant

Step 1: Determine whether you have to make payments. If total payments—including income taxes, self-employment tax, alternative minimum tax, additional Medicare taxes on earned income and net investment income, and taxes for household employers—is $1,000 or more, just pay the taxes when you file your return. There won’t be any penalty.

Step 2: Decide how much to pay each installment. You can avoid penalties by using a safe harbor. There’s no penalty if you pay 90% of this year’s taxes through withholding and/or estimated taxes. Or you can pay 100% of last year’s bill (110% if your adjusted gross income last year was $150,000 or more, or $75,000 or more if married filing separately). Special rules apply to farmers and fishermen. If these safe harbors don’t work for you, project your income for the year, figure taxes on it, and then divide by four so that you pay the total amount through the four estimated tax installments.

Step 3: Decide how to pay your taxes. If you have a job, you can increase withholding to cover additional liability for self-employment income, taxable retirement plan distributions, household employer obligations, and more. If your spouse has a job and he/she agrees to increase withholding, that covers you as long as you file jointly. Check for voluntary withholding options, such as on Social Security benefits.

Conclusion

Work with your CPA to ensure that you meet your tax obligations. In paying estimated taxes, remember that if you overpay it’s like making an interest-free loan to the government, and if you underpay, you may owe penalties. Finally, be sure to have the funds on hand to meet your payment needs. This may require setting aside part of your earnings so the money is there when you need to send it to the government.