Freelancing and contracting work are great ways to be your own boss, but with that comes special tax rules and responsibilities.
Here are the key things you need to know about paying estimated taxes.
- If you are earning income without any taxes withheld, and you are going to owe at least $1,000 of tax on that income, you need to be making estimated tax payments.
- If you don’t make estimated tax payments, or don’t pay enough, the IRS and state governments might charge a penalty for underpaying your estimates (even if you expect a refund).
Do I have income without withholding?
A common sign that you have income with no withholding is income reported to you on any of the 1099 forms. These forms are provided usually by clients (for freelancers) or from financial institutions (for investment income). Be aware that these forms are also sent to the IRS and the state tax authority as well as provided to you. The government knows you’ve gotten this income and expects to receive a tax payment in the form of estimated payments.
Another way of knowing if you have a tax responsibility is if you receive money for a service or product you provide over $400 in a year. This includes online sales or services, consulting and side gigs. It does not include unpaid products or services to family and friends, or services provided in volunteering. Simply put: if you made over $400 for something you actively choose to do, it’s definitely reportable and probably self-employment.
Who Has to Pay Estimated Taxes?
- Freelancers and independent contractors,
- Workers with side gigs (such as drivers for Uber, and Lyft, Postmates),
- People who are representative
- People with rental income (such as from Airbnb),
- People who sold assets with significant capital gains (such as selling a house), and
- Any one receiving income without taxes being withheld.
What sort of taxes do I owe?
Income tax is calculated based off of the sum of all the income items, which includes income from self-employment, rentals, capital gains and others. The basic calculation is to take net income, see what tax bracket you fall into, and multiple that net income by the applicable tax percentage. This is a rough estimate of your taxes due.
It’s important to know that it’s not just income tax that is owed, but also Self-Employment Tax (SE Tax) for people who actively earn other income. The key thing is that it’s income you actively worked for, meaning you dedicated time and some resources to getting that income.
Steven is a real estate agent who helps people sell their homes. He also recently sold his condo. He isn’t an employee and receives his income on a 1099 from a broker.
The act of Steven working for income as a real estate agent means that income is active (or rather non-passive) and he is acting as a self-employed person, subject to SE Tax. Steven selling his house, however, is not something Steven has done to actively seek income but rather for potentially different personal reasons (eg, looking for a bigger condo) so it isn’t subject to SE Tax.
However in both instances, Steven has to make a tax payment. He has to calculate the taxes owed for his real estate business and his house sale, and then figure out the SE Tax only to his real estate income.
SE Tax is an additional tax that goes to fund government support programs like Social Security and Medicare/Medicaid. The current rate for the SE Tax is 15.3%, which is calculated on top of income tax. While this may seem like an extra tax, self-employed people are allowed to deduct the “employer half” of SE Tax from their taxes.
When do I pay my taxes?
Many people think that taxes are due in April, and they’re technically correct. There is a better way to avoid a big bill in April and that is by paying quarterly, which is what we recommend most people do.
There are two reasons why. First taxes are actually due throughout the year (its required), and not following this rule can incur a penalty even if you expect a refund. Secondly, paying tax as income is earned through the year eliminates the need for a big tax payment in April.
For many people, paying their taxes all at once is a significant cash-flow problem. It can be quite a challenge to some, if they haven’t been saving beforehand. Paying quarterly is not just what the IRS and most states require, but also makes great business sense. It reduces the stress around April and allows for people to be nearly worry-free.
Lucy is has a day-job as an employee at a software company and her salary is $50,000. This income places her in the 22% tax bracket and her job at the software company will withhold at that income. On the weekends, she drives for Uber and Lyft to make extra money.So far this year, Lucy has made $5,000 of income from her side gig as a driver.
Since Lucy is in the 22% any income she makes, up to $82,500, will be taxed at 22% for Federal tax. $5,000 multiplied by 22% is $1,100. That quick estimate shows Lucy is going to owe more than $1,000 of tax, and it makes sense for her to start making payments of tax throughout the year.
But what about the SE Tax?
Driving for Uber and Lyft is considered a self-employed activity, because its work Lucy actively does on her own. That means this $5,000 of income from a side job is subject both to the income tax (22%) and to the self-employment tax (15.3%). That’s a combined rate of 37.3% in Lucy’s situation. That means Lucy’s tax bill is closer to $1,865.
That $1,865 is due in quarterly installments of about $466, which is a lot easier to handle than one giant bill in April that may include penalties.
How to make tax payments throughout the year?
The process is called paying estimated taxes.
We recommend that if you’re in the position that you seek out a tax advisor, as there are a few more factors that go into the calculation of your estimated payments. Remember your taxes due are calculated on all of the income you receive but different income is taxed differently. It’s important to know those rules.
Don’t forget about state taxes! States also have to get their fair share and many states have unique rules for paying those taxes.
The IRS maintains two websites to accept payments
You can pay directly from your bank account but be aware that making tax payments with a debit or credit card will incur a payment processing charge.
Be sure to keep your payment confirmations! Give the payment confirmations to your tax advisor when it comes time to prepare your return. These confirmations are your proof you paid your taxes.
What are the deadlines for paying estimated taxes?
There are four deadlines for income earned during 2018 throughout the year:
- April 18, 2018 (for income earned from January to March)
- June 15, 2018 (for income earned from April and May)
- September 15, 2018 (for income earned from June to August)
- January 16, 2019 (for income earned from September to December)
Remember there are penalties for not paying your estimated payments. The current penalty is 4% compounded monthly of the liability until the day its paid.
Working off our example earlier for Linda and her $1,865 tax owed to the IRS, the underpayment penalty she would incur if she waited till April to pay is just over $155 which is nearly half one of the estimated payments themselves. The underpayment penalty brings Linda’s total tax to over 40%. And remember, there’s state tax on-top of that to consider, and they have their own penalties.
What do I do if I think I owe?
Speak to a tax advisor. Tax advisors can help you figure out how much you owe and advise you on the best way to set up your estimates. Visor provides year-round tax planning for just these sorts of situations. We work to adjust your tax payments to fit your needs and pay the right amount of tax, saving you money and putting you in the best position possible.
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