There are plenty of sources of income not nipped by withholding: income from self-employment, investments, rents, alimony, some prizes, etc. But avoiding withholding doesn't mean escaping the government's pay-as-you-go demands.
The program's Payment Planning Worksheet will calculate whether and how much estimated tax you owe at various times during the year. You must estimate your projected taxable income for the year, the amount of income and Social Security tax you'll owe and how much, if any, of it will be paid via withholding. The easiest way to make your estimate is to use your previous year's return as a guide.
Take a stab at how income and deductions are likely to differ in the current year and apply the latest tax rates to the best guess of your taxable income. If self-employment income is involved, be sure to take into account what you'll owe in Social Security taxes.
For 2006, if the gap between what you expected to owe and the amount you expected to be withheld is $1,000 or more, you might have been expected to make estimated payments.
Those payments are due only if failing to make them would subject you to the penalty for paying too little during the year. That means that if you want to hold estimated payments to a minimum—a worthy goal that lets you keep more of your money working for you during the year—you need to understand the underpayment penalty and the exceptions to it.
The penalty is the IRS's not-so-subtle reminder that taxes are due as income is earned, not just on April 15 of the following year. Basically, it works like interest on a loan, with the penalty rate applied to the amount of estimated tax due but unpaid by each of four payment dates during the year. The penalty rate is set by the IRS and can change each quarter. It was 8% beginning July 1, 2006.
Never accused of oversimplifying things, the IRS doesn't break the tax year into four three-month quarters. The first quarter is three months (January 1 to March 31), but the second "quarter" is two months long (April 1 to May 31), the third is three months (June 1 to August 31) and the fourth covers the final four months of the year.
The installment payments are due on April 15, June 15, September 15 and January 15 of the following year. You can skip the final payment if you will file your return and pay all the tax due by February 1. If a due date falls on a weekend or legal holiday, the deadline is pushed to the next business day.
You don't have to make any payment until you have income on which estimated taxes are due. If you know early in the year that you must make estimated payments, each of the four payments should be 25% of the amount due.
But what if you receive income during the third quarter that, for the first time, makes you liable for estimated tax payments? Your first payment would be due on the third installment date—September 15—and you are expected to pay 75% of the tax that is due.
To hold your payments to a minimum, base each installment on what you have to pay to avoid the penalty, using any exceptions that benefit you.
If you have a tax refund coming from the IRS, you can elect on your return to have part or all of the money applied to your estimated tax bill. Although the IRS doesn't pay any interest on such advance payments, it may make sense to use the refund to pay the first installment (due April 15) and perhaps even the second (due June 15) just to save yourself the hassle of writing and sending in the checks.
After you send in an estimated tax payment with its payment voucher, the IRS will automatically send you a package of preprinted vouchers showing your name, address and Social Security number. The payments are made to the IRS service center for your area.
For a discussion of the estimated tax penalty, see the help for underpayment of estimated tax.