Income drop and safe harbor

[CI Guy]

I'm self-employed and will see a big drop in my 2025 income from last year (which was W2 income with automatic withholding). I just realized that my estimated quarterly payments are way under the 110% safe harbor and I'll see an underpayment penalty at filing. I read about the Annualized Income Installment Method, but am unsure how to go about it starting now in Q3. What should I be doing at this point to mitigate any issues come filing time next year? 

[robtm]

You should increase your next 2 quarterly payments so you make the total estimated payments at least equal to the 110% amount to avoid the under payment penalty.

[baldietax]

why are you paying 110% of your 2024 tax If your income has significantly reduced in 2025 then you should be paying estimated tax based on 90% of your 2025 tax, have you done that estimate/calculation?

[baldietax]

so just add once you figure out what is smaller (110% of 2024 vs. 90% of 2025) if you haven't paid Q1/2 ES for that amount, you will have some penalty but only for a few months if you get those caught up the penalty will stop accruing.  By Q3 ES Sep deadline you need to have paid 75% of the annual ES total, 100% by Q4 in Jan.

AI method helps if you have uneven income and associated tax payment especially later in the year like a Roth Conversion.  If your income was even thru the year (or front-loaded), but you missed estimated tax payments earlier in the year, the AI method will not eliminate those penalties as it will still show you underpaid in Q1 etc.

[Mike9241]

with all the tax law changes it will be hard to know what 90% of your 2025 tax will be. in addition, while your income will be lower and hence your income taxes will be lower but then you will have no withholding. you will also have self-employment tax which would be about 15% of your net se income.

 a very rough way to estimate 100% of your 2025 tax would be to take your 2024 taxable income subtract out the taxable wages and add in your estimated se income. then use the 2024 tax rate schedule (see 1040 instructions page 109) to calculate income taxes to that add 15% of the SE income. There is no way to know how close this will be to your actual 2025 tax because of the need to estimate your se income for the whole year.  

https://www.irs.gov/pub/irs-pdf/i1040gi.pdf 

depending on what you estimate your 2025 tax to be (i'm ignoring the 90% rule) without withholding 75% needs to be paid in by the 3rd quarter 

if you have penalties, you will be able to use the annualized income installment method to see if that reduces them.  

[CI Guy]

Ok, so I'll use 1040-ES to calculate my 2025 income (it's actually very steady, except for investment income) tax and liability. The 75% number by Q3 is good to know. I can make extra payments in the meantime. So the Annualized Income Installment method isn't really in play unless I end up with a large underpayment penalty? 

[baldietax · Accepted solution]

Generally, the AI method helps if you make uneven/late ES payments which line up with uneven income, in particular if that occurs late in the year so the higher quarterly estimated taxes couldn't be planned thru the year (e.g. Roth Conversion in Q4, but you made smaller ES payments in Q1-3 not taking the Roth conversion income into account, and then a much larger one in Q4).

IRS penalty calculation by default assumes your income is even thru the year (divides total by 4) to line up with quarterly ES payments; the AI method provides a way to specify your AGI/tax liability by quarter instead of assuming it is even by default.

But if your income is even, and you make late ES payments just because they're late not because your income changed, the AI method will likely still determine you underpaid in the earlier quarters, it's not a solution for missing quarterly payments that were due.

When you come to file for 2025 you can always run thru the AI process in TT under Other Tax Situations / Underpayment Penalty to see if it reduces the penalty and then TT gives you the choice whether to file with that method or not.

Note on your comment - 1040-ES doesn't calculate income it's just a form to file the estimated tax (and try to pay electronically online at irs.gov and be sure to select 2025 tax year and 1040-ES as the type of payment - no voucher/check needed).  To estimate income you'll need to use some tax calculator; TT 2024 desktop can be used to run a hypothetical return but won't take into account 2025 tax brackets/deductions and other changes from the big bill; or follow method suggested by @Mike9241.