Managing taxes as a self-employed business owner is one of the most challenging parts of entrepreneurship. Part of the challenge is calculating estimated taxes. Especially when you don’t have an employer withholding taxes for you. The United States is a pay-as-you-go tax system. In other words, when you make money, Uncle Sam wants his cut.
This is where quarterly tax payments come in. As you make money throughout the year, taxes are due each quarter. So if you expect to owe $1,000 or more in taxes, you need to make quarterly payments. Not only do you have to pay income tax, but self-employment taxes are also part of estimated tax payments.
A common rule of thumb you’ll hear is to set aside ~30% of your gross income for taxes. Gross income is what you make before taxes and deductions. If you want to fine-tune your estimated tax payments, the IRS has a worksheet you can use. This worksheet can be a handy guide but let’s break down how to estimate your tax payments.
To maximize your money and minimize your tax bill to Uncle Sam, it important to estimate your taxes as accurately as possible. We will cover calculating your total tax payment, which includes both income tax and self-employment tax. Over your lifetime, somewhere between 20 to over 40 percent of your earnings will go to Uncle Sam in the form of taxes. So make sure you work with your financial professional to reduce tax as much as possible to keep more money in your pocket.
If your self-employment income is pretty stable from year to year, a good place to start is with your last tax return. First, you’ll want to look at adjusted gross income. Then subtract the standard deduction or expected itemized deductions (if you itemize). This number will give you an idea of your expected income for the current year.
Once you have an estimated income number, use the federal tax brackets to get an idea of your tax liability.
Planning note: Each taxpayer is entitled to the standard deduction. This is a standard amount that reduces your taxable income. Therefore, if itemized deductions add up to more than the standard deduction, you’ll likely itemize.
Self-employment tax usually comes as a surprise for most self-employed business owners. If you work for a company as an employee, you pay half of your social security and medicare tax. Your employer pays the other half. Social security is 12.4%, and Medicare is 2.9% for a total of 15.3%. In other words, as an employee, you would pay 7.65% (half of 15.3%), and as a self-employed person, you pay the full 15.3%. This is the self-employment tax.
To cushion the increased taxes from self-employment tax, you get to deduct half of this as a business deduction.
To calculate your self-employment tax, take your estimated net income. Your net income is the income from your business minus business expenses. Take this income number and multiply it by 92.35%. Why 92.35%?! The federal government only taxes 92.35% of net self-employment income. This also helps minimize the impact of self-employment tax.
Once you have this number, multiply it by the self-employment tax rate of 15.3%. This is your estimated self-employment tax.
Planning Note: Social security tax is paid on the first $142,800 in 2021. This IRS adjusts this regularly. Medicare tax jumps up to 3.8%, with wages above $200,000 for single taxpayers and $250,000 for joint taxpayers.
You have calculated your estimated income tax and self-employment tax to combine these two numbers to get your estimated tax liability from self-employment.
All you need to do is divide this by four to get your estimated quarterly tax payment. You can pay this in equal amounts if your income is expected to be stable. If you have uneven or unpredictable income throughout the year, you’ll want to recalculate your estimated taxes each quarter. You must pay enough tax that you don’t get penalized, which will be discussed below.
Planning note: If you have other income sources (e.g., a spouse is a W2 employee), withholding additional tax from W2 income can cover or reduce estimated tax payments.
Estimated taxes are due by the following deadlines:
Estimated taxes aren’t necessary if you meet these three specific requirements:
The IRS may penalize you if you don’t make sufficient tax payments throughout the year. This penalty is determined by how late you pay and the amount of your underpayment. Of course, they won’t penalize you for paying more, but you want to avoid paying too much or too little.
Here are three ways to avoid a tax penalty:
The IRS will accept payments electronically through IRS Direct Pay. This is the easiest way to make your tax payments with a bank account, debit, or credit card.
For businesses and those with large tax payments, use the Electronic Federal Tax Payment System (EFTPS). This program requires enrollment, so don’t wait until the last minute.
Understanding the mechanics of taxes as a self-employed person is important. Winging it or making mistakes can result in an audit or giving Uncle Sam too much money. If your state or city has an income tax, you’ll likely have to make estimated tax payments to those places. Check with your particular state. The information we have covered is for federal taxes. If you want to learn more about tax planning for your self-employed business or want to talk through your estimated taxes, schedule a call with me!