Freelancers and Estimated Taxes: 5 Answers You Need to Avoid Penalties
America’s tax system is actually based on a pay-as-you-go model, however, most of us don’t realize that because the April 15 "Tax Day" is such a big deal. So much talk centers around that day that it’s easy to forget most people paid taxes all year long through income withheld by their employer.
If you're a freelancer, the burden of paying taxes falls entirely on you. Clients don’t save back money from your payments to send to Uncle Sam, and there are no more “gross” and “net” segments on your paychecks. Instead, freelancers are expected to make tax payments throughout the year. They’re called estimated tax payments because the amount you pay is based on an estimate of what you expect to earn. Anyone who makes more than $1,000 in earnings per year is expected to pay estimated taxes. Failure to comply results in penalties, and those penalties will depend on how much you owe in taxes and how long you haven’t paid.
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1. How much in tax do I pay?
Freelancers should expect to pay both income tax and self-employment tax. The self-employment tax runs around 15% of your taxable income. It covers Social Security and Medicare, two of the taxes generally withheld by employers.
To figure out what you will owe, you can look at line 24 of your previous year’s 1040. That’s what you paid last year in taxes, and if you’re expecting your income to remain about the same, you’ll pay this year. If this is your first year working as a freelancer, you can use the IRS Form 1040-ES to help calculate the amount of taxes you’ll have to pay.
The hard part for most new freelancers is to guess what your income will be. Chances are you didn’t take the plunge to freelance unless you had a few clients already lined up. Use the information from those payments to annualize and expected salary and give your income your best guess. Take heart in the fact that the penalty is .5% of what you owe, so it typically won’t be a massive burden if your estimate is a little off the first year.
2. When do I make tax payments?
Estimated taxes are paid quarterly:
April 15 of the current year
June 15 of the current year
September 15 of the current year
January 15 of the following year
The dates might vary one or two days if the 15th falls on a weekend or holiday. Also, the January payment can be paid at the end of the month if you file your current year’s taxes by January 31 and make your payment then.
You have to pay at least these four times, but you can pay estimated taxes throughout the year. Some freelancers choose to pay monthly to make it easier to budget for the payments.
3. How do I pay?
The 1040 ES form includes a payment voucher that can be mailed in (make sure to have your payment postmarked by the due date). You can also pay by phone or online from your bank account. If you choose to pay with a debit or credit card, there are additional fees.
4. How can I prepare?
The best way to account for estimated tax payments is to do the withholding yourself, just like an employer would. A general rule of thumb is to set aside about 25-30% of your income for tax purposes. Each time you get paid by a client, take a percentage out of that and put it into a savings account set aside for your tax payments. You could also make the deduction monthly rather than per payment.
5. What about state taxes?
Yes, you also have to report your income to the state. The amount of tax due and when will vary according to each state’s regulations.
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