Transcription
Every April I see two types of business owners. The first one says, "Why do I owe so much?" And the second one says, "Wait, why did I send the IRS that much money?" You know, one of those is panicked and the other one feels robbed. But both of them made the same mistake. They treated estimated taxes like a guessing game.
Now, if you are a business owner, quarterly payments, they're not optional. But overpaying is, and underpaying that just gets expensive. Today I'm going to break down how we help small business owners dial this in so they're not overpaying, they're not underpaying, they're just strategically paying exactly what makes sense. So let's dive into this.
And the first concept that I want to talk about is just how the US tax system works. The US is considered a pay as you earn system. So basically that means that you owe taxes as you earn income related to that. And a lot of people, I think this comes as a surprise because they file their tax return in April and they think, "Oh, there's a refund or there's an amount due in April." They don't really realize that really they're supposed to be paying taxes as they earn it.
Let's look at two different types of people to help this make sense. Think of a W2 employee. You get your gross [clears throat] wages, so whatever your gross salary is, and then your employer takes all these taxes out, and then you get your take-home pay. That's whatever is left over. So that take-home pay is what you use to spend, buy all these different things for for your family and everything else. But your employer took taxes out. Now the employer takes those taxes out of every paycheck and then throughout the year they're sending those taxes to the state agencies to the federal government. So the employer is doing this for you. They're paying taxes as you earn it. Now you might just not think of it that way cuz you only do a reconciliation of your tax return at the end of the year.
But as a business owner, here's where you get confused. You no longer have that employer that's pulling all these taxes out and paying them on your behalf. You're responsible for that. And that's where estimated taxes come in. But that's where there's confusion. Estimated taxes are due when you earn the income, not at April 15th. April 15th is just a reconciliation to say, "Here's what we've earned. Here's all of our deductions. Here's how much we paid in or didn't pay in for estimated taxes. Here's what our actual tax is. And now we either get a tax refund because we overpaid the IRS or we have an amount due because we didn't pay the IRS enough." That's not necessarily when taxes are due. They're due when they're earned. So that's the first thing I want people to understand. The US is a pay as you earn type of system.
So now let's talk about the real problem with estimated taxes. The first main thing is people don't do them correctly. Most business owners when they think about taxes, they base their estimated taxes based on last year's income or they just send in whatever feels safe or they just send in a random number or or worse, they don't do anything. And we see this a lot especially with first-year business owners. They ignore them until there's penalties and interest, all sorts of fees and things line up for them. It can get really, really bad. And we see this especially for new business owners where they're not used to having to pay estimated taxes and all of a sudden they get that tax bill in April and they're like, "Wow, I don't have the cash to pay for that." So, they start to make they get on a payment plan, they start to make those payments, but now they're already behind because when they're making those payments for last year, they should be making estimated payments for the current year. And so, it's that snowball that can just continue to run down the hill and just just become bad and and lead into different things. And that's why if you're a new business owner, I hope you're hearing this early enough that you can start to take some action on that.
So, main problem is most business owners base uh their estimated tax payments on last year's income or they just send it whenever feels safe or they don't do anything at all. And that's going to be interest penalties and all different things. But the thing is is that your income changes, your deduction changed, the tax law changes, especially last year there was a big tax bill. Even your entity structure might change. And estimated taxes shouldn't be reactive. They should be engineered. You know, if you guess wrong and you either give the IRS an interest-free loan or you pay penalties and scramble in April.
So, I want to talk through this process about how we start to go about making estimated tax payments. Now, when we talk about estimated tax payments, there's two [music] safe harbor rules, and these are important. We're going to talk about why they matter. And this is where strategy begins cuz to avoid penalties, you generally need to fall into one of these safe harbors. And there's two safe harbors. The first one is 100% of last year's tax liability or the second one is 90% of this year's tax liability. So if you pay 100% of last year's tax liability in the form of estimated payments, you are not subject to interest or penalties or if you pay 90% of this year's tax liability and estimated tax payments, you're not going to be subject to interest and penalties if you underpaid. Now that first one, 100% of last year's tax liability, if you have a higher income, that actually turns to 110%. So just keep that in mind. That might be something that's relative to you.
Now, most business owners stop here. But here's here's the thing. The safe harbor avoids penalties. It does not mean that you're optimized. So you could still be massively overpaying or underpaying. Let's just say we did the the last year's tax liability method for this. And let's say last year you made $100,000 of income. So you're making estimated tax payments on that. You're meeting the safe harbor. But this year your income hits $500,000. Sure, you're not going to have interest or penalties on that mispayment, but you still are going to owe those taxes when it comes to April. So, just keep that in mind that even though there's no interest or penalties, the tax amount is the tax amount. The tax owed is the tax amount. So, that's going to be having to be paid at that time anyway. So, those are the safe harbors. If you want to make sure you avoid interest or penalties, make sure you do those 100% of last year's tax liability, 110% if you're a high income earner, or 90% of this year's tax liability. Those are the safe harbors. That when you do your reconciliation, when you file your tax return in April, if you've hit one of those safe harbors, you're not going to be subject to interest and penalties. There's still going to be an amount due.
Now, let's talk about overpaying. Then, this is what I always call kind of a hidden cash flow killer. Let's say that you had a big year last year, and now you're having just a normal year, which is totally fine, or even maybe even a down year, but you are still sending payments based on that inflated prior year income. [snorts] Now, think about that. You're overpaying. And you're thinking of last year's income, even though this year's going to be a down year or you had a really good year that you don't expect to have this year, but you're still making payments based on last year's income and going to be paying way more in taxes than you need to, which means you're going to get a refund at the end of the year. But what could that money be being used for this year? It could be used for uh funding marketing campaigns. It could be used for paying down debt or investing in equipment or sitting in even a high yield interest savings account helping you increase some of the savings that you have. But instead, if you make that overpayment, it's sitting with the IRS and they're not paying you back with interest or at least not a rate that you can get out on the open market. So overpaying can be really detrimental as well.
A lot of people, they base their success of taxes based on a refund or an amount due. That is not the way to look at it because guess what? I can make everyone get a refund. Just way overpay 50% of your paycheck into the IRS and an estimated tax payment or through W2 withholdings and guess what? You're going to get a refund. That doesn't mean you paid less in taxes. It just means that you overpaid in taxes throughout the year. And I think that that's an important concept to understand when it comes to estimated tax payments.
Now, the opposite of that is underpaying. And this is what I call the stress multiplier. The opposite is business ramps up. You're profitable. You're excited. But you would never adjusted estimates upward. And then all a sudden, April comes and you owe a big balance plus maybe underpayment penalties and interest if you didn't save however correctly. So now you're when that tax bill comes, you're liquidating cash, you're swiping credit cards, or you're draining reserves, not because you didn't earn enough, but you just didn't plan properly. And so those are the two problems that we run into. Underpaying, which I call the stress multiplier, or overpaying, which is a cash flow killer. And that's why we want to kind of drill this in and find that happy medium on what makes sense.
Now, quick pause. If you're listening to this thinking, I have no idea if I'm overpaying or underpaying right now. We put together something specifically for business owners who want clarity. It's our tax savings starter kit and it walks you through the most overlooked tax deductions. It goes through real client case studies where we save people $5,000 to $25,000 or more and it includes an opportunity to talk directly with our team at tax about your situation. So if you want more predictability around your tax bill, go to taxsavingspodcast.com/starterkit. That's taxsavingspodcast.com/starterkit.
All right, now let's get back to it. So how do we avoid both of those scenarios, overpaying and underpaying? Step number one, do a quarterly profit analysis. We don't guess. We review actual numbers. Now, this would mean that you have to have accurate and up-to-date bookkeeping. Let's look at revenue. Let's look at expenses. Let's look at new deduction, payroll changes, entity changes throughout the year. And let's analyze how we're doing in that specific quarter.
The step two is you project forward, not backward. So, we want to forecast what the rest of the year is [music] looking at. Are we growing? Are we hiring? Are we buying assets? Are we planning distributions? Maybe we had a great summer, but we don't expect that to continue. Or maybe we had a down summer, but we expect it to go up in the winter. Seasonality. We're looking and forecasting what does this year look like it's going to be. And then we adjust.
Step three is adjust intentionally. Sometimes we're going to lower estimates. Sometimes we're going to increase them. Sometimes we're going to shift strategy entirely, but the key word is being intentional with the estimated tax payments that you're making.
Now, the cash flow strategy that most people miss, and here's what high-level business owners do differently. They separate a tax savings account, their operating account, and their profit distributions. And then every month, they move a percentage of their income into a tax bucket so that when quarterly payments are due, it's already funded. There's no stress. There's no scrambling to see if there's money there. It's already funded. So, they might say, "Okay, we're going to take x% of our profit and we're going to put it into uh a tax savings account." And then when it comes time to pay taxes, the money's already sitting there. We're not scrambling to get it. This is very smart. This is a cash flow standpoint. And making sure that you're not spending money that really is not quite yours because it's really owed to the government when you earn those funds.
So, let's talk about due dates of estimated tax payments. Remember, you need to pay as you earn. So, when is it due? Quarter 1, which is January, February, March, is due April 15th. Quarter 2, which is only two months, April and May, [music] is due June 15th. Quarter three, June, July, and August are due September 15th. And quarter 4 which is September, October, November and December are due January 15th. So these are for the estimated tax payments. Remember the US is a pay as you earn system. So you need to make those tax payments relative to the quarter that you earn that money in.
Now the big picture, let's kind of wrap this up and look into this. Estimated tax payments done correctly create stability. They create predictability, stronger cash flow, and there's no surprises when it comes to April. That's so important. And I don't want people to be surprised one way or the other because it can really dysfunction in and create a a a dysfunction the way their business operates. But if you do estimated taxes poorly, they create anxiety. They create missed opportunity. They create poor cash flow or missed opportunity on money that was spent that could have been in your hands helping you grow your your business. So when we talk about this, we're not talking about paying less recklessly. It's all about paying correctly, strategically, and confidently.
Now, there's two safe harbor rules. Safe harbor meaning that if you make this at a minimum, you're going to avoid penalties. You generally need to pay the lesser of 100% of last year's tax liability or 110% if you're a high income earner or 90% of this year's tax liability. So 100 or 110% of last year's tax liability is a safe harbor or 90% of this year's tax liability is a safe harbor. That helps you avoid penalties. The due dates for estimated taxes are quarter 1, January, February, March, due April 15th. Quarter two, April and May due June 15th. Quarter three, June, July, and August due September 15th. And quarter 4, September, October, November, December, due January 15th.
The thing I always talk about estimated taxes is don't run and try to avoid the situation. Take estimated taxes by the horn. Get ahead of yourself. Take this seriously and make sure that you are prepared for yourself. It makes you a better business owner. And make sure that your money is working in the areas that you want your money to be working in in your business. And it [music] makes life easier and less stressful for you.
Here's the bottom line. Estimated taxes shouldn't feel like roulette. If you're guessing every quarter, if you're after leaking cash or there's building future stress for you, there's a smarter way to run this. If this episode helped you think differently about how you handle quarterly payments, make sure you subscribe so you don't miss future strategies. And if you want our team to help you build a proactive tax plan, not just react every April, head on over to tax, that's t-a-x-e-l-m.com, and schedule a free discovery call with our team. We work with business owners every day to legally lower their tax bill and eliminate surprises. Thanks for listening and I will see you on the next.