Most people are familiar with tax withholding on their W-2s, which is required by law. However, taxpayers also earn income from other sources, not subject to mandatory withholding; for instance, a business owner's net profit or an investor's dividend or capital gain income.
Individuals with these types of income sources (no mandatory withholding) are encouraged by policy to pay quarterly estimated tax payments. And failure to do so, may result in an estimated tax penalty, an additional fee tacked-on to the original tax liability.
The estimated tax penalty is calculated based on current interest rates (the federal short-term interest rate plus three percent, compounded daily). From 2009-2022, interest rates were maintained at an historic low, and many taxpayers were more willing to pay the estimated tax penalty in exchange for holding funds up until the due date of the tax return (typically, April 15 of the following year).
But times change, and in the current interest rate environment, the estimated tax penalty is much more significant. Currently, the IRS interest rate for individual underpayment is 8%.
A final consideration as to why estimated taxes are important: Cash flow.
Making regular estimated tax payments may help to prevent a sudden drain on liquidity when tax liabilities come due. By spreading your tax obligation across multiple payments, you are likely to heed greater control over your cash flow and avoid liquidity crunches on tax day.
We should note, the estimated tax penalty is not to be confused with other IRS penalties and interest, such as the penalty for failure to file, the penalty for late payment (after April 15), and the interest that accrues on a late payment. In this post, we only speak about the estimated tax penalty.
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