In this episode of ThimbleberryU, we dive into a topic that often catches even financially savvy people off guard—estimated taxes. Many assume taxes are fully handled through paycheck withholdings, but we unpack why that assumption can lead to nasty surprises, especially for professionals in tech and healthcare.
We start by defining what estimated taxes are: quarterly payments made directly to the IRS when withholding isn’t enough to cover total tax liability. This often applies to small business owners, but also to high-income W-2 employees who receive RSUs, ESPP income, large bonuses, or mid-year raises. Amy shares real-life examples of clients whose withholding fell short, either because RSUs were taxed at a flat 22% while their actual bracket was higher, or because payroll systems didn’t account for mid-year raises, leading to unexpected tax bills and underpayment penalties.
We then explore the IRS’s pay-as-you-go approach. If you've underpaid during the year—even if you pay in full by April—you could still face penalties. Jag and Amy emphasize how the system annualizes income, so a raise in July can retroactively affect your tax liability starting in January. This is where estimated taxes kick in, sometimes unexpectedly after filing the previous year’s return.
To determine whether you're subject to these payments, we explain the IRS safe harbor rule: if you pay 90% of your current year’s liability or 110% of the prior year’s, you generally avoid penalties. We walk through the process of calculating your total tax liability, subtracting what’s already been withheld, and deciding how to handle any shortfall—either through increased paycheck withholding or quarterly payments to the IRS and state.
Amy reminds us that overpaying gives the IRS an interest-free loan, so it's often best to aim for accuracy. Tools like financial planning software and coordination with a CPA can make this process manageable. The key is to review and adjust quarterly so you’re not blindsided come tax time.
We close with key takeaways: estimated taxes aren’t just for freelancers, income changes—whether yours or a spouse’s—can affect your liability, and proactive planning with a financial advisor and CPA helps avoid surprises. Most importantly, working with both professionals ensures smoother execution and better results.
ThimbleberryU 141 - Estimated Taxes — What They Are, Why They Matter, and How to Handle Them
[Music playing]
Jon Gay (00:07):
Welcome back to ThimbleberryU, I'm Jon Jag Gay. Amy Walls from Thimbleberry Financial joins me as always.
Good to be with you, Amy.
Amy Walls (00:14):
Jag, it's great to talk to you.
Jon Gay (00:15):
And today, we're talking about a topic that tends to sneak up on people. This is a really important one: estimated taxes. If you've ever owed a big tax bill in April and thought, wait, didn't I already pay taxes on this? This episode is for you.
Amy, 101, we’ll start here. What are estimated taxes, and why should our listeners care?
Amy Walls (00:34):
(Laughs) Great question, Jag. At the simplest level, estimated taxes are payments you make directly to the IRS, usually four times a year (if you're subject to them) when your paycheck withholding isn't enough to cover what you owe. So, when I said paycheck withholding, small business owners may need to make these more commonly, but it is fairly common that W-2 employees also need to make these.
Think of them as your way of keeping the IRS “up to date” on your income as it happens. The U.S. is a pay-as-you-go tax system. And that doesn't just apply to people who are self-employed. So, this is a place, like I said, where both self-employed and salaried professionals get tripped up, especially our clients in tech and healthcare.
Jon Gay (01:23):
I know we're going to focus on those two areas. That's kind of your wheelhouse. So, let's say I'm getting a regular paycheck, my taxes are being withheld. Why would I still need to send these extra payments, these estimated taxes to the IRS?
Amy Walls (01:35):
That's the key misunderstanding that people have about these estimated payments. So, even if you have W-2 income, not all your income is withheld correctly, especially when you're at higher income levels or have bonuses or equity compensation.
Let me give you a couple of examples in the form of stories. So, someone, we’ll call Joe, had RSUs that vested every quarter. Now, RSUs (Restricted Stock Units) are like taxes, ordinary income, the way a paycheck is taxed, and they assumed taxes were covered.
Because what happens (we've talked about it in prior episodes) is some shares are held back to pay the tax bill. And so, the person whose shares are vesting, they're getting a smaller number than what vested.
But the company, the employer, only withheld 22% on the withholding for those RSUs at their vest time. But the client's actual tax bracket was 35%. That's a 13% gap on six figures of income that becomes shocking. And they were shocked, rightfully so.
Jon Gay (02:51):
So, the math in my head real quick, even at $100,000, that's $13,000. So, it'll be $13,000 for every hundred grand they're making. Yeah, that's significant.
Amy Walls (02:59):
And then let's talk healthcare. Someone we know received a mid-year pay increase as part of a pay equity adjustment. Her paycheck looked great, but the payroll team didn't adjust the withholding, and quite honestly, nor should they be expected to.
But sometimes people think, “Oh, they should probably trigger me to fill out a new W-4.” Nope, that's the employee's responsibility, really. So, the higher income coupled with her withholding choices created a tax shortfall that she wasn't expecting.
Jon Gay (03:35):
Again, nasty surprise come April. So, what you're saying, Amy, is it's not just extra income that causes issues; it's income where the tax withholding is too light or it's delayed or isn't quite where it needs to be.
Amy Walls (03:47):
Exactly, Jag, you've got it. The IRS also doesn't wait until April to collect, that's something important. If you've underpaid throughout the year, you may also owe underpayment penalties even if you pay everything in full by April 15th of the following year.
Jon Gay (04:07):
That's a really important point.
Amy Walls (04:09):
So, in the example I just used about the person in healthcare, her pay raise obviously happened midway through the year. But the way the IRS calculates that, let's say that the first half of the year she actually had been fine on her withholding, but it's just the second half where there was a gap. They actually go back and annualize that, so the gap actually still applied to early in the year.
Jon Gay (04:36):
Oh, geez.
Amy Walls (04:37):
So, you kind of have to play catch-up when that's the case. Let's say you're now going to owe for third quarter because of this pay change, you're going to have to make up for what you missed in first and second quarters at the same time.
Jon Gay (04:52):
Amy, this stuff is really complicated, and as we're going to talk about later, this is why you really need to work with a team of professionals. But first, let me ask you, what triggers this? What kinds of income do people need to watch out for?
Amy Walls (05:04):
For our clients, these are the big ones. Tech professionals should watch for RSU vesting, ESPP sales, and large year-end or even mid-year bonuses, just large bonuses, let's say. Because even though some tax is withheld, it's rarely going to be enough.
For healthcare professionals, we often see issues when they get large bonuses, retroactive pay increases, or raises that hit mid-year but don't have updated W-4s.
Another area that surprises people and can catch them in this estimated tax issue is capital gains. So, if you sell investments during the year (say to rebalance your portfolio or harvest losses), you may trigger a gain that doesn't show up on your paycheck. And that's going to play in. So, it's what you have coming in an income plus what you have happening with your investments.
The other thing that we have not touched on yet that I think is really important is part of why this surprises people is, let's say that we were to go through all of 2025, we've never had estimated payments, not a thing, not a worry, and all of a sudden, we have changes. We don't know that these have triggered the need for estimated payments.
And it's not until our 2025 taxes get done that we get the alert that says, “Uh-oh, there was under withholding, and for 2026, you now need to pay these payments.” And so, April 15th comes with, “Okay, I need to pay what I owe for 2025, but I'm also going to need to pay my first quarterly payment for 2026” because there's some rules around when you have to pay going forward.
Jon Gay (06:58):
If you pay quarterly estimates, that first quarter is due April 15th, along with anything you may owe from the previous year. But I want to go back for a second because I want to make sure I understand this correctly.
It's that first year that's triggered a need for estimated taxes that you would find out when you file the return, and then you have to pay estimated taxes going forward from there. As opposed to I've never paid estimated taxes in my life, all of a sudden, I find out retroactively I need to, right?
Amy Walls (07:25):
Pretty much. But just because you start making estimated payments, it doesn't mean you'll pay them for life. They can stop if you've had enough withholding. It's based on a couple of things.
Jon Gay (07:40):
Well, that actually leads me to my next question, Amy, so how do people know if they're safe or at risk of having to pay these estimated taxes?
Amy Walls (07:47):
So, Jag, that's where the IRS safe harbor rule comes into play. If you have paid at least 110% of your previous year's tax payments or 90% of this current year's tax payments, the IRS basically says you're going to get to avoid your penalties.
Jon Gay (08:05):
Okay, good.
Amy Walls (08:06):
But if you haven't met those thresholds, you're going to need to pay penalties on top of your regular tax bill. And these estimated payments are intended to get you to those thresholds so that you won't have to pay extra.
Jon Gay (08:21):
That makes sense. The last thing we want to do is pay more taxes, more fees, more penalties, things like that.
Amy Walls (08:27):
Exactly.
Jon Gay (08:28):
The burning question I've had as we've been talking here, Amy, how do people actually handle this? What should someone do if they think they might owe estimated taxes?
Amy Walls (08:36):
Alright, so you know I'm a little bit process-oriented.
Jon Gay (08:39):
Just a little. (Laughs)
Amy Walls (08:39):
Just a little. So, here's the basic process. Number one, estimate your full-year tax liability. Now, we do this for clients using planning software updated when we know that income has shifted. So, for example, new RSU’s are vesting or a pay raise comes in, we are able to look at that and have a projection (now we're not CPAs) of what the total tax bill will be based on the full picture. But people can do that on their own too.
Then you need to look at how much tax you've already paid via withholdings. So, how much has your employer withheld, and how much have you paid in estimated payments already? And if there's a gap that you're seeing, that's a great time to either say, I better up these estimated payments or probably before you do that, hopefully you have a CPA and you're working with a CPA to say, “Hey, life change happened here, let's recalculate.”
Number three is decide how to pay it. So, we're talking people who are employed, not self-employed. So, they can, one, adjust their W-4 and increase withholdings for the rest of the year. So, this happens on a per-paycheck basis rather than making quarterly estimated payments.
So, if you're somebody who is likely to forget or just cringe every time you get that reminder to pay those taxes and you hate sending the check off, automate it with increased withholding on your paychecks. And if you are paying it directly, you can make direct payments online to the IRS using their website or your state's website, if state estimated taxes are applicable.
Jon Gay (10:26):
I'm glad you said that because in many states that is applicable. I know here in Michigan I do estimates, I pay for federal, and I pay state quarterly here. So, do people tend to overpay just to be safe?
Amy Walls (10:37):
Some do. Especially we find it with our tech clients, but overpaying does mean that IRS holds your money interest-free. So, we want to try to help clients get it right so they're not out of pocket unnecessarily.
But peace of mind of knowing you're not about to get hit with a $50,000 extra tax bill and you'd rather pay as you go and not be wondering what money's what, if that really brings you that much peace of mind and you can afford to do it, well, then peace of mind is a great thing.
Jon Gay (11:08):
I know personally I have a separate account that I save for my quarterly tax payments, and it's an interest-bearing account. I know you'll be proud of me when I tell you this, Amy. And I keep the tax money in a separate interest-bearing savings account, and then I just pay it quarterly when it's due because I'd rather collect the interest on that money than have the IRS do it, right?
Amy Walls (11:27):
And that's perfect, yep.
Jon Gay (11:29):
This is really complicated stuff, Amy. Is there a way to avoid estimated payments altogether?
Amy Walls (11:34):
Sometimes, yes. If you are only slightly underpaid, you can increase your withholdings to make up the difference. So, if you see this gap that I'm owing each year is getting a little bigger, maybe just adjust your W-2 or your W-4 so that the W-2 withholding will be better.
But here's where it gets even smoother than that. And we don't give tax advice, like I said, at Thimbleberry, but we do coordinate with your CPA, as do many financial professionals. So, that means one, we help identify when estimated taxes might be needed based on income changes like RSU vests or a raise.
We also then prep and organize information your CPA needs. Things like projected income, taxes already withheld, capital gains from a rebalance, or something like that. We have that information in reports that we can just hand off to a CPA with a client's permission.
And most of the time what CPAs say is, “Oh my gosh, I don't need to evaluate anything because I've got the report and the information all in front of me. And so, I can just use this, and I now have a quick and easy answer for our shared client.”
Jon Gay (12:42):
You make me think of a corporate cliché that I roll my eyes at every time I hear it, and here I am going to say it: “Teamwork makes the dream work.”
Amy Walls (12:49):
(Laughs) Yep.
Jon Gay (12:50):
And it's funny you mentioned this because, as I mentioned, I pay quarterly taxes, and we're recording this in July, so we’re a little more than halfway through the year. And my wife and I had some changes financially this year where some stuff went up and some stuff went down, and we were looking at it, and we said, “Hmm, we might not be paying enough in the quarterly estimates.”
So, we sent the information off to our CPA, to your point, and said, “Hey, can you rerun these numbers?” And the team came back to us and said, “Actually, yeah, we're going to have you pay more for your Q2, Q3, Q4 estimates to make sure that you're covered given these changes in your income so we feel good about where we're headed into tax season 2026 through 2025.”
Amy Walls (13:31):
And that's perfect. That's a great story. I actually have a similar story, but in reverse, Jag, from this last year. We had to file an extension for a few reasons, and we were given our estimated tax payments based on what was done for April 15th.
So, we owed (obviously if we're paying estimates), paid quarterlies, and then when our taxes got done, we actually owed less, so we were then going to be getting a fairly decent refund from all of the entities, IRS, state, et cetera. We have some local taxes too that we have to pay quarterlies on.
But as a result of that, and my CPA didn't actually volunteer it at the time, I said, “Whoa, whoa, whoa, if we're now getting a refund and our quarterlies were based on that, we need to recalculate our quarterlies because they're all going to be way too high.” And so, they looked at that and said, “Yep, lower these.”
Jon Gay (14:29):
Absolutely.
Amy Walls (14:29):
And that's a win (laughs).
Jon Gay (14:31):
Yeah, for sure. You really need to work with professionals on the financial advice side and the CPA side when it comes to this stuff. But other than that, Amy, what are the key takeaways? What should our listeners walk away with from this episode?
Amy Walls (14:42):
The main takeaways, I think, are estimated taxes aren't just for freelancers or the self-employed. That's a common misconception.
Two, if your income changes through bonuses, stock vests, raises, whatever, and keep in mind that this can be your spouse's income also, right?
Jon Gay (15:01):
If you're filing jointly, yeah.
Amy Walls (15:02):
Think jointly. If you are married, filing jointly, you may owe more than what your paycheck is covering. Planning ahead and checking in quarterly can save you stress, money, and IRS penalties.
And last thing I'd say is when your financial planner and CPA are working together, you get proactive solutions, not surprise bills.
Jon Gay (15:23):
I like that. Amy, if somebody listening wants to contact you and your team at Thimbleberry Financial regarding this or anything related to their finances, how do they best find you?
Amy Walls (15:31):
They can reach us thimbleberryfinancial.com or by giving us a call at (503)-610-6510.
[Music playing]
Jon Gay (15:41):
Great stuff as always, Amy. We'll talk again in a couple weeks.
Amy Walls (15:43):
Sounds great, Jag. Thanks.
Voiceover (15:45):
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer, member of FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions. Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer, member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.