Why Do We Pay Taxes?
They say there are only two things in life that are certain, and that is death and taxes, but why do we pay taxes throughout the year? There are two different types of taxes that we prepay: estimated quarterly taxes and taxes withheld on your W-2. I know many people look at their paycheck and see a lot of money being withheld, or if you own your own business, you are paying those estimated taxes quarterly. But how does that benefit you?
W-2 Payroll Employees
We’re going to start with W2 and withholdings on those paychecks. You will likely have federal and state withholding.
However, if you live in a state that does not have an income tax, you will not have this line. The whole point of having these withholdings is so you do not owe any income tax at the end of the year. This relies on you filling out a W-4 correctly and ensuring that all deductions and other income are accounted for.
The IRS released a new W-4 around 2018 that would help them be more accurate when it comes to withholdings. As a result, many people saw fewer refunds because they were keeping that money throughout the year. That is really the goal; they do not want you to owe extra, and they do not want to have to refund you.
This typically happens automatically when you fill out the W-4. If you have a payroll processing company, they will handle all of this for your employer. You should be within around $100 to a couple of hundred dollars refund or owing if this is filled out correctly.
1099 Contractors and Small Business
The nice thing about employers using payroll software is that they are doing 80% of the background tax items. Most people will pay the taxes to the IRS or the state themselves, rather than having their employer do it.
They also file all necessary paperwork to ensure compliance. While filing all the paperwork is a task, depending on the business size, the employer will have to pay at different times. Smaller businesses will pay in quarters, while larger businesses may pay in weekly installments.
However, if you are a 1099 contractor or a business owner, you will need to consider estimated taxes (see the estimated tax blog). If you are a 1099 contractor, you’ll have to prepare to pay taxes on the total of all the 1099s that you receive from all vendors. The total tax due will include self-employment taxes, which account for the Medicare and Social Security that would be withheld from a W-2. Many people are not prepared for the amount of tax they will owe.
For business owners, the net income of the business will be passed through if you are an LLC, S-Corp, Partnership, or similar entity. The net income will be taxed at your tax rate, and many business owners do not realize how much that could truly cost them in total at the end of the year.
Estimated Taxes
This is where estimated taxes come in. Say you made $100,000 as a small business and have a net income. If you owe $25,000 in taxes on that $100,000, you could make estimated payments of $6500 each quarter, which would account for even a slight increase. It is difficult to calculate the exact amount that will be owed because your net income is constantly changing, which is also a reason to make estimated quarterly payments.
These quarterly payments give you some idea of how much you’re going to owe and make the final number a lot more palatable than if you owe the $25,000 up front. You can pay on a quarterly basis on April 15th, June 15th, October 15th, and January 15th.
If you do not estimate payments, they will compare your income from last year with your tax liability from last year and determine how it has changed from the current year. This could lead to significant penalties if you have not paid in at all, depending on how much was owed last year compared to this year.
If you have paid 90% of last year’s tax liability or 100% of the current year’s tax liability, you are considered paid up for estimated taxes. As tax accountants, we would much prefer receiving a $ 1,000 check at the end of the day than a $25,000 check because you didn’t prepare throughout the year to pay your taxes.
What’s the Benefit?
While the benefits of making smaller payments throughout the year are easier on your cash flow, avoiding penalties and interest are the truly significant benefits. We have unfortunately seen up to $ 6,000 in additional penalties and taxes due to underpayment of estimated taxes.
One major question we are frequently asked is how to pay less in taxes. If you pay these estimated taxes, you can avoid any additional taxes that you may be charged for interest and penalties. Another thing that people don’t realize is that even if you get an extension for filing your taxes beyond April 15th, you still owe the full tax liability at the time the taxes are due.
Withholding and prepaying through estimated taxes will help you understand your tax liability for the year and will already have you partially paid up for the entire year.
If you take nothing else away from this blog, please take away the importance of correct withholdings and time-only estimated payments. It gets complicated, and if you ever do find yourself needing help with estimated taxes. Waterford can assist with small business accounting and complex taxes.
Our goal is to provide knowledge to contractors and anyone who may not understand their financials but wants to. You can always reach out to us at 864-351-0852 or info@waterfordbusiness.com for more information and a complimentary consultation on how we can enhance your business.
