Individual taxpayers in certain situations are required to make estimated tax payments in order to minimize or eliminate the exposure to the penalty for underpayment of estimated tax.

Individuals must pay 25% of a “required annual payment” by Apr. 15, June 15, Sept. 15, and Jan. 15, to avoid an underpayment penalty. When that date falls on a weekend or holiday, the payment is due on the next business day.

The required annual payment for most individuals is the lower of 90% of the tax shown on the current year's return or 100% of the tax shown on the return for the previous year. However, if the adjusted gross income on your previous year's return was over $150,000 (over $75,000 if you are married filing separately), you must pay the lower of 90% of the tax shown on the current year's return or 110% of the tax shown on the return for the previous year.

Most people who receive the bulk of their income in the form of wages satisfy these payment requirements through the tax withheld by their employer from their paycheck - but not necessarily. Those who make estimated tax payments generally do so in four installments. After determining the required annual payment, they divide that number by four and make four equal payments by the due dates.

But you may be able to use the annualized income method to make smaller payments. This method is useful to people whose income flow is not uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business that you operate in a resort area during June, July, and August, no estimated payment is required before Sept. 15. You may also want to use the annualized income method if a significant portion of your income comes from sales of securities that are made at various times during the year.

If you fail to make the required payments, you may be subject to an underpayment penalty. The penalty equals the product of the interest rate charged by IRS on deficiencies, times the amount of the underpayment for the period of the underpayment.

However, the underpayment penalty doesn't apply to you:

• (1) if the total tax shown on your return is less than $1,000 after subtracting withholding tax paid;
• (2) if you had no tax liability for the preceding year, you were a U.S. citizen or resident for that entire year, and that year was 12 months;
• (3) for the fourth (Jan. 15) installment, if you file your return by that Jan. 31 and pay your tax in full; or
• (4) if you are a farmer or fisherman and pay your entire estimated tax by Jan. 15, or pay your entire estimated tax and file your tax return by Mar. 1

In addition, IRS may waive the penalty if the failure was due to casualty, disaster, or other unusual circumstances and it would be inequitable or against good conscience to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (after reaching age 62) or become disabled.

Bear in mind that using the annualized income method typically requires calculations of the estimated tax and, if a professional is doing the calculations, there is a cost for those services.  If interest rates are relatively low, as they have been for many years, the opportunity cost of not investing the funds is minimal.  In many cases, even if larger quarterly amounts are required, it is prudent to not annualize and simply pay based on the prior year's final tax liability.