I was asked in another thread and forum about this. Rather than hijack that topic, I am posting here.
@MIRN
This question comes up on VJ, because sometimes a new immigrant has the opportunity to continue to work for a foreign employer as a contractor. Contractors will not have taxes deducted from their pay, and so it is up them to pay their taxes. It would be simpler if contractors could just pay their entire tax liability in the April following each tax year, but doing so risks penalties as the IRS wants to be paid at least once per quarter.
Quarterly estimated taxes are complicated because:
* even if you pay what you owe each quarter, you can still be hit with an underpayment penalty if your income is highly variable. So for example you are in the 10 percent tax bracket for the first 3 quarters of the year, and then on the four quarter you get a large payment that puts you in the 37 percent tax bracket. Technically you under paid for those first 3 quarters though the IRS gives you the option of breaking down your revenue and expenses by quarter to avoid the penalty. It is basically 5 + 4 = 9 tax returns. That s complex.
* the quarters are not each exactly 3 months. Quoting from the IRS:
Estimated tax payments are due as follows:
- January 1 to March 31 April 15
- April 1 to May 31 June 15
- June 1 to August 31 - September 15
- September 1 to December 31 January 15 of the following year
So one quarter is 2 months and another is 4 months.
While most of my income has been W-2 income, I have had years with high percentages of variable pay whether from contracting or bonuses (bonuses have lower tax with holding than their actual tax liability). Over the years I have learned the following tips:
* Assume that contractor income will be taxed at 35 percent. Even if your tax bracket is as low as 10 percent, you still owe 15.3 percent SE tax. Even if your marginal tax rate is high as 37 percent, you won t owe the full 37 percent on all income because of the progressive tax brackets. And SE tax drops from 15.3 percent to 2.9 percent well before you hit the 37 percent tax bracket. Of course, earn enough money and you will be hit with the 0.9 percent medicare surtax. So generally the 35 percent rule keeps most contractors safe. So each time you get revenue, put 35 percent of it in a separate bank account and do not touch it until you make a quarterly payment, or pay any taxes owed in April
* If over the course of say tax year 2023 you pay 110 percent of tax year 2022 s tax liability you will not in April 2024 owe any penalties, provided you make 4 equal estimated tax payments in 2023. So if in 2022 you had a tax liability of $20,000, then 1.1 * 20,000 / 4 = quarterly payments of $5500 per quarter in 2023.
* you can avoid underpayment penalties if you or your joint filer spouse have a W-2 job and 110 percent of your tax liability from the previous tax year is paid from the W-2 job s tax with holdings. You can do this by filing a W-4 with your employer to request additional taxes to be with held. This is my preferred way to do this, because this way I do not have to remember my quarterly tax payments
So let s try some examples:
You work in the U.S. remotely in 2023, and did not work in U.S. in 2022. You expect to gross $100,000 as a contractor in 2023.
Since your 2022 tax liability was zero dollars. the 110 percent rule says you are excused from making quarterly tax payments. You still reserve $35,000 in a separate bank account for paying taxes. In April 2024, you determine your tax liability is $30,000. You pay the IRS $30,000 out of your reserve fund.
110 percent of $30,000 is $33,000. $33,000 / 4 = $8250. You make an estimated tax payment for tax year 2024 on April 15, 2024. And again on June 15, Sept 15, and Jan 15, 2025.
Continuing from the above, in 2024 your income was $103,000. The tax liability is $31,000. You paid $33,000 over year.
You are due a refund of $2000. However, you might instead apply that to 2025 estimated taxes. So:
$31,000 * 1.1 / 4 = $8525. So for April 15, 2025, you make an estimated tax payment of $6525. For the other quarters you pay $8525.
As above but your spouse decides to change the W-4 instead of you making estimated tax payments.
There are say 16 pay periods left in 2025, so your spouse files a W-4 requesting 31,000 * 1.1 / 16 = $2133 extra with held from each paycheck. To make up for the short falls in household cash flow, each time your spouse is paid, you transfer $2133 from your reserve account to your joint account. You let the IRS send you the $2000 refund.
Continuing with the above, April 2026 arrives. Your spouse had gross W-2 income of $150,000 and the W-2 shows $60,000 in income tax with held. You had $125,000 in contractor income.
Your joint tax liability on a combined $275,000 income is $56,000. You take the $4000 refund. Your spouse has paid $25,000 to date.
110 percent of $56,000 is $62,000. $62,000 - $25,000 = $37,000. $37,000 / 16 = $2312. Your spouse files a new W-4 changing the extra with holding from $2133 per pay period to $2312.