Freelancers and independent contractors know there is nothing easy about having to write a check to the United States Treasury four times a year to pay estimated federal income taxes. The Internal Revenue Service, the agency charged with collecting federal taxes, knows too.
The number of people hit with penalties for underpaying their estimated tax has been on the rise, according to an IRS report from October 2017. It showed 10 million taxpayers paid penalties of up to several hundred dollars in 2015. That was up nearly 40 percent from 7.2 million in 2010.
Part of the reason more taxpayers are having to pay penalties for underpaying estimated taxes may be the rise of the gig economy, including members of the sharing economy (such as ride-sharing drivers) and people with two or more jobs as well as freelancers and independent contractors. But whether their ranks are growing or not, paying estimated federal income taxes remains a special headache for freelancers.
One pain point resides in the fact that the IRS schedule for making estimated tax payments requires two payments representing half the year's estimated taxes to be made just 60 days apart, in April and June. “This is a tough period of the year," says Mary Tindall, a freelance writer in Winter Park, Florida. Tindall says she copes by consulting in advance with her accountant and tax advisor and consistently saving a portion of her earnings for estimated taxes.
The rewards of owning my own business definitely outweigh the tax-related hassles.
—Mary Tindall, freelance writer
One of the big differences between freelancers and wage earners at conventional jobs, whose employers withhold taxes for them, is that freelancers like Tindall must set aside and pay their own estimated taxes. Freelancers who need to pay estimated taxes include anyone who paid taxes last year and expects to owe at least $1,000 in taxes for the current year.
The mechanics of paying estimated taxes seem straightforward, although in practice it’s a little more complicated. The following tips can help break down the basics and make paying taxes easier for freelancers.
Preventing Potential Headaches
The first problem with paying estimated taxes is estimating the amount. The IRS allows two methods to avoid underpayment penalties. Taxpayers can either pay 100 percent of what they owed last year, or 90 percent of what they expect to owe this year. The 1040-ES IRS tax form that must be filed with each estimated payment has detailed instructions on how to figure the amount.
Tindall estimates using 90 percent of the current year's projected taxes. “I've found that accurate bookkeeping is critical," she says. “It's easy to underestimate how much you're making from month to month. By monitoring it closely, I'm able to keep unpleasant surprises to a minimum."
Don't forget to adjust estimated amounts due if you have major fluctuations in income if necessary, adds Paul Joseph, a CPA and attorney with Joseph & Joseph Tax and Payroll in Williamston, Michigan. “If you have a great quarter, you deposit more. If you have a not-so-great quarter, you deposit less. But you have to keep track and structure it. It gets to be a bit complicated."
Keeping complete, accurate and well-organized records will help freelancers estimate their quarterly tax payments accurately, says Jennifer Failla, a certified financial planner with Strada Wealth Management in Austin, Texas. Freelancers who use accounting software will find their programs can produce these calculations quickly and relatively easily as long as they keep up on data entry.
Those who rely on manual bookkeeping can also do the job. The key is tracking income and expenses accurately and in an organized fashion, according to Failla. “We have people do this in envelopes of receipts," she says. “Start with your envelopes of receipts. If you're not computer-savvy, no problem."
Solving the Payment Problem
Calculating the amount of estimated taxes due is one thing. Having the money available to pay them is another. The most recommended solution is to divert a set portion of earnings from each payment for freelance work as it arrives.
“Every dollar you bring in, you start socking some aside," says Failla. She recommends at minimum 15 percent. Joseph suggests 25 percent or more. The exact percentage, of course, depends on a freelancer's annual income, deductions and tax bracket. Freelancers may want to include planned tax-deductible contributions to retirement savings accounts.
One of the hard facts about estimated taxes is that the amount a freelancer needs is likely to be significantly more than the paycheck withholding for a wage employee with a similar income. That's because an employer pays the Social Security Administration half of Social Security and Medicare taxes, amounting to 6.2 percent of wages up to $128,400 for Social Security and 1.45 percent on all wages for Medicare, or 7.65 percent combined. Freelancers pay both halves themselves, for a total of 15.3 percent, in addition to whatever ordinary income taxes are owed.
Once you've figured out how much to pay and have set aside the money, the most straightforward way to pay estimated taxes is to pay equal amounts for each quarter. But taxpayers also have some flexibility. “On the form, there’s a method you can elect that allows you to adjust your payments according to the flow of income," Joseph says.
Another key point about paying estimated taxes is that a taxpayer may still owe more on April 15 despite correctly paying 100 percent of last year's taxes or 90 percent of the current year's projection. “All that means is you don't have to pay the late payment penalty," Joseph says. “You still have to pay the tax."
Tindall says she makes sure to set aside a generous 33 percent of every payment from a writing client, keeps careful records to help with accurately estimating her current year tax obligations and as a result manages to get through each estimated tax payment without undue trouble. “The rewards of owning my own business definitely outweigh the tax-related hassles," she says.