April 15 has come and gone, but it will come again, and sooner than you think. If you barely squeaked in under the deadline this year and ended up either paying more in taxes than you anticipated or wound up getting a large refund of estimated tax because you’re still getting the hang of this self-employment thing, you aren’t alone.
To help you better deal with the tax man, this article takes a look at the single most important thing that independents operating as sole proprietors can do to keep up with taxes throughout the year. Not only will it make your life easier for the first two weeks of next April, but following this simple rule can also save you money by preventing you from paying too much in taxes in your estimated payments or by helping you avoid penalties and fees for underpayment. And don’t forget, if all or most of your income isn’t subject to withholding, you get to pay taxes throughout the year, not just in April.
Maintain a separate account for your taxes
When you were an employee, the most obvious number on your paycheck, the total amount payable to you, was all yours to keep. Only by looking at the check stub was it evident how much you were paying in taxes because your employer had already taken it out and set it aside for Uncle Sam.
However, as an independent with 1099 payment status, the total amount on that check is in your hands immediately. It’s very tempting to think of it as all yours, but it isn’t. You will have to pay a portion of it in taxes. And thanks to the 15.3 percent self-employment tax that’s in addition to federal income tax, you’ll pay more now than you did as an employee.
The best way to handle this situation is to establish a separate account dedicated to the amount you anticipate having to pay. Most banks will allow you to set up a miscellaneous savings account in addition to your regular checking and savings. Or, if you maintain a separate account for your business, make sure it has at least two sub-accounts.
When you cash each check, place a set percentage of it into this account every time. After a while, doing so makes the process almost as easy as when you were an employee: You know that you have to set that amount aside, so you don’t look at those digits on the check the same way. Setting money aside will make it much easier and less painful to make your estimated tax payments because you won’t have to scramble to come up with tax money.
How much should you set aside?
As you probably know, you have to make estimated tax payments every quarter in which you earn income not subject to withholding. Determine a round number to set aside from every checkŸit’s too time-consuming to calculate your exact tax based on your current expenses for every check. A good rule of thumb is to set aside 35 to 40 percent.
If this sounds like a lot, take a look at your tax returns from last year. If all of your income was from self-employment and you had few business deductions, you probably paid close to this amount in taxes. What you set aside should be based on the following tax rates:
- Federal income tax: 28, 31, 36, or 39.6 percent (approximate your annual income and see the IRS’ tax tables for this year to determine your tax rate).
- Self-employment tax: 15.3 percent to cover Social Security and Medicare taxes.
- State tax: According to the state you live in, this may be from 0 to 8 percent and upward.
As you can see, these numbers quickly total more than 40 percent.
Of course, the amount you end up paying is calculated based on your adjusted gross income (AGI), which is subject to some confusing calculations. Basically, your AGI is your gross income minus:
- 7.65 percent of your total income (you’re taxed on only 92.35 percent of your self-employment income).
- One-half of your self-employment tax (just to make things confusing, it seemsŒ).
- Business expenses.
So, you may well end up paying out somewhat less than 40 percent.
Following this simple rule of thumb can make for a nice quarterly bonus. I always set aside 38 percent. The only exception I allow is when I have substantial business expenses: I’ll subtract that amount from my next check before I sock away that 38 percent. When the next estimated tax deadline rolls around, I’m always able to fold at least a couple hundred dollars into savings or checking, left over from my calculated tax due.
Calculating the tax due every quarter
One of the downsides of being an independent is getting to figure taxes not once, but four or five times a year. Before the 15th of April, June, September, and January, you’ll calculate your taxes from that quarter and send a check to the IRS and probably another to your state treasury. Whatever’s left in that account is yours to keep. If you didn’t set enough aside, following the 35 to 40 percent rule should at least have put you close enough that you don’t have to dip far into your savings.
You’ll find worksheets to help you figure the exact numbers in IRS Publication 505. (To download the file, search for 505 and select your desired format.) The Estimated Tax Worksheet calculates four equal payments throughout the year; the Annualized Estimated Tax Worksheet is for independents with irregular income. These worksheets take into account your AGI plus your estimated itemized and personal deductions. For advice on when to use which worksheet, see my earlier article "Do you need to make an estimated tax payment this quarter?"
Note that these worksheets calculate only 90 percent of your tax burden, which is usually the minimum you must pay to avoid a penalty. Because my income is quite irregular, I use the Annualized Estimated Tax Worksheet and then adjust the number it calculates so I pay 100 percent of what I owe. While I could keep that money and earn interest with it, I’d rather not worry about whether I’ll have to pay a penalty.
Here’s another tip to simplify your quarterly calculations: On this form, I stop at line 21, Annualized Income Installment, because it tells me everything I need to know. The remaining lines assume that you’ve worked through the other worksheet and proceeds to take you through circuitous calculations to compare line 21 with the results from that worksheet. However, that worksheet is useless unless you receive roughly the same amount of money every quarter. I don’t take the time to fill it out, even though the publication advises that you do so. Of course, if you have specific tax questions, you should seek advice from a qualified tax professional.
Meredith Little has worn many hats as a self-employed writer, including technical writer, documentation specialist, trainer, business analyst, photographer, and travel writer.Have you devised any time- and money-saving methods for filing quarterly taxes? To share your thoughts, post a comment below or send us a note.