It's common for self-employed income to yo-yo from month to month — which makes it stressful to plan for quarterly taxes. How can you know how much you’ll owe for the year if you don’t know how much you’ll make all year?
Luckily, there’s a way to account for irregular income when you pay your quarterly taxes: the annualized income installment method.
What is the annualized income installment method?
The annualized income installment method is a way of splitting up estimated quarterly tax payments for people whose income fluctuates throughout the year.
Who should use the annualized income installment method?
CPA and financial advisor James Allen described this method as particularly helpful for self-employed workers who tend to receive large, one-time payments, “like a novelist receiving a large royalty check or a realtor closing a significant sale.”
It can also be useful for taxpayers “whose income varies due to factors like bonuses, commissions, or stock options,” said CPA Elise Faucette, a senior associate at Utah-based accounting firm CMP.
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How do quarterly tax payments usually work?
Typically, quarterly tax payments are calculated assuming that you:
- Have steady income throughout the year
- Know how much you’ll be making that year by April
Under the regular method, you’ll use your projected income to estimate your total tax bill for the year. Then, you’ll divide that into four equal pieces to pay.
The regular installment method can be rough on self-employed people with unpredictable income. The annualized income installment method, though, lets you pay less tax when you earn less money.
How popular is the annualized income installment method?
It's not commonly used. “Per IRS data, around 10% of taxpayers obliged to pay estimated taxes utilize [it],” Faucette said. “It’s likely that many taxpayers are unaware that [it’s] an option.”
However, the annualized income installment method can “save you from late payment penalties and help you keep your cash in your own pocket during periods of reduced income flow,” Faucette said.
Does the annualized income installment method help you avoid penalties?
Yes — as long as you actually make your installment payments in full.
Taxpayers who annualize their income can still find themselves facing penalties “if they haven’t paid enough through their estimated payments to cover the required installments for the specific period,” said Andrew Gosselin, a CPA and former senior tax strategy consultant who serves as senior editor of Money Inc.
In other words, if you miss or undershoot a quarterly payment, you can get slapped with penalties whether you’re using the regular or annualized method.
What tax form do you use for the annualized income installment method?
You’ll need to submit Form 2210 to use this method. It’s officially titled “Underpayment of Estimated Tax by Individuals, Estates, and Trusts,” but don’t worry. As mentioned, you’re using it here to avoid underpayment penalties.
In Part II, the “Reasons for Filing” section, check box C. This tells the IRS that you’re submitting the form in order to use the annualized income installment method.
The specific part of the form that deals with annualizing income is called Schedule AI. You’ll find it on page three of the form.
When do you file Form 2210?
You’ll submit this form once a year, on Tax Day in April. Send it in with your regular 1040 tax return.
When do you pay quarterly taxes under the annualized income installment method?
Using this method, you’ll still pay quarterly taxes on the same due dates as everyone else:
- April 15
- June 15
- September 15
- January 15 of the next year
Essentially, your filled-out Schedule AI is your way of retroactively explaining to the IRS why some of your quarterly payments were smaller than others.
Now, let’s talk about how you annualize your income using the form.
How do you calculate annualized installment income?
When you figure out your annualized income, you’re essentially looking at a few chunks of the year and asking, "If my income for the whole year looks like my income for this period, what would it be?"
It takes a few steps to figure this out.
Step #1. Split your year into four periods
On Schedule AI, you’ll see these four periods labeled with lowercase letters:
- January 1 to March 31 (a)
- January 1 to May 31 (b)
- January 1 to August 31 (c)
- January 1 to December 31 (d)
As you can see, these periods nest into each other, like a Russian doll. The second period encloses the first period, and so on. The fourth and final period covers the entire year.
Step #2. Find your AGI for each period
On line 1 of the form, you’ll enter your adjusted gross income (AGI) for each period. That means doing two things:
- Figuring out your net income from self-employment
- Taking out your adjustments to income
Figuring out your net income from self-employment
Your AGI is based on your net income — which means you’ll want to take out your business write-offs first. For the annualized income installment method, you “need to keep track of your… deductions for every single day of the year,” said Gosselin, the CPA and finance publication editor.
If you don’t keep track of your expenses throughout the year, you’ll risk overpaying on quarterly taxes. You’ll get the extra back as a refund, but you’ll essentially be giving the IRS a loan.
“It can be a bit of a hassle [to track expenses],” Gosselin acknowledged. “But for those with inconsistent income, it’s definitely worth considering.”
Keeper can take the hassle off your hands. Our app automatically scans your transactions for eligible write-offs. That leaves you more time for the parts of your business or side hustle that only you can do.
If you sign up for the premium plan, you'll even get an EA or CPA to handle your quarterly taxes for you.
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Taking out your adjustments to income
You’ll take your net income and remove certain “adjustments” — tax breaks that include:
You’ll find all possible adjustments to income in Part II of your Schedule 1, part of your Form 1040. Once you subtract them from your net income, you’ll have your AGI.
Step #3. Annualize your income from each period
Now that you have your AGI for each period, you’re ready to annualize it. That means extending it out to see what your income would look like if you earned at that rate for the rest of the year.
You’ll do this by multiplying your AGI for each period by a certain “annualization amount.” In lines 2 and 5 of Schedule AI, you'll see these pre-filled for you in a different font:
- 4 for period (a)
- 2.4 for period (b)
- 1.5 for period (c)
- 1 for period (d)
To see how they work, pretend your AGI for period (a) was $12,000. Using the annualization amount for the period, 4, you’ll find that annualized income is $48,000: $12,000 times 4.
What are these annualization amounts based on?
The annualization amounts represent how much of the year has passed by the end of each period.
The one for period (a) is 4, because the three months from January to March are one-fourth of the year. In other words, you have to multiply your income for that period by 4 to stretch it out to the whole year.
As you can see, the last annualization amount is just 1, because period (d) is the whole year. To annualize your income from that period, you only need to multiply it by 1.
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The annualized income installment method in action
How does this help people with fluctuating income? Let's talk through an example involving a seasonal side hustle.
Say you have a part-time online business selling ski gear. Your income depends a lot on how cold it is outside.
Period (a): January to March
You have a strong start to the year, thanks to some great weather for hitting the slopes. From January to March — period (a) — your AGI is $15,000.
Multiply that by the annualization amount for period (a), which is 4, and you can see you're on track to hit $60,000 for the year!
Period (b): January to May
Spring rolls around, and things slow down. From April to May, you make $2,000 in AGI. That means your AGI from period (b) is $17,000.
Multiply that by the right annualization amount (2.4), and your annualized income becomes $40,800.
Period (c): January to August
Summer hits, and business is even more sluggish. Between June, July, and August, you earn $1,000. Now, your total adjusted income in period (c) is $18,000, because ($15,000 + $2,000 + $1,000).
Multiply that by 1.5, and you get $27,000 for your annualized income.
Period (d): January to December
Once the weather gets colder, your business heats up again. From September till the end of the year, your shop makes $10,000 in AGI. That means your total income for this period is $28,000. That’s $15,000 + $2,000 + $1,000 + $10,000.
Because this final period covers the entire year, that’s also your actual annual income. That’s why your annualization number is 1.
In this example, your shop earns a lot less money when the weather’s hot. With the annualized income installment method, you get to pay less tax during those lean times and catch up after ski season.
No matter what you do for work, annualizing your income can take the uncertainty out of quarterly taxes. Just make sure you’re keeping up with everything you spend to do your job — something Keeper can take care of for you.
Forget to write off these expenses, and even annualized income can’t save you from overpaying the IRS.
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At Keeper, we’re on a mission to help people overcome the complexity of taxes. We’ve provided this information for educational purposes, and it does not constitute tax, legal, or accounting advice. If you would like a tax expert to clarify it for you, feel free to sign up for Keeper. You may also email support@keepertax.com with your questions.
