One of the unknowns that tends to go hand-in-hand with self-employment is lack of certainty about how much income you’ll earn each year. The Internal Revenue Service (IRS) is set up to receive quarterly estimated tax payments on a “pay as you go” system, so that you shouldn’t find yourself stuck with a massive income tax bill on April 15th. What you want to avoid, though, is known as “under-withholding.” This term means, quite simply, not putting enough money away for Tax Day each spring.
High earners may need to up their estimates
If you’re a person of average means, federal taxes haven’t changed all that much in several decades (although state and local taxes could be said to have raised the tax rate overall). At the very high end of the earnings spectrum, though, changes enacted in 2013 continue to have an effect. Married couples who make $470,700 and single filers who make over $418,400 are now in a higher tax bracket – up from 35% to 39.6%.1 Note that even a small percentage owed on your high income taxes can amount to several thousand dollars. Moreover, not paying the estimates on time can result in penalties and interest. On top, there is an additional Medicare tax for high earners, and this can add another 0.9%, to up the bill further.
How much should you put aside?
Most self-employed people make an educated guess and use a formula based upon the numbers they brought in last year to calculate how much to put aside for taxes. In 2017, the IRS generally wants this to be either 90% of this year’s taxes, or 100% of the tax shown on the tax return of the previous year.2
Best strategy to use
The number one remedy for under-withholding is to avoid allowing a problem to occur. Make an appointment with your accountant well ahead of time each year, preferably at the halfway point of Sep 15. Have them run tax projections, comparing your current withholding with estimates based on your income thus far. If you have both W2 and self-employment earnings, get your employer to hold back more. If you’re fully self-employed or own a business, increase your next two personal quarterlies. Don’t worry about overpayment--it can be refunded when you file your return. While this may amount to a free loan to the US government, most people would agree that it’s preferable to having the IRS come after you.
2. IRS, “Topic 306: Penalty for Underpayment of Estimated Taxes,” IRS.gov, January30, 2017
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