Estimating Taxes for Self-Employed Individuals
The following is general information regarding estimated taxes for self-employed individuals. For detailed information about current tax law and regulations, contact the IRS or a tax professional for assistance.
Who must pay estimated taxes
If you are an independent contractor – a consultant, a freelancer, or have your own business – and expect to owe at least $1,000 in federal income tax, you are required to pay estimated taxes throughout the year. The purpose of the estimated tax system is to ensure that all taxpayers have paid enough tax by the end of the year to cover most of their tax liability.
Computing your estimated tax
Estimated tax is the taxpayer's tax liability reduced by withholdings and tax credits. If you have employees, FICA (Federal Insurance Contributions Act withholdings for your employees benefits) will also be subtracted, and if your state has income tax, you will also be expected to pay state estimated payments. To avoid an underpayment penalty on the unpaid amount, your estimated tax must be at least the lesser of the following:
- 90% of the tax liability shown on the return for the current year, or
- 100% of the tax liability shown on the return for the prior year
Many taxpayers find it difficult to estimate their quarterly payments and are uncertain whether their withholdings and estimated tax will equal or exceed 90% of their actual tax liability for the year. You may want to use the "safe planning" technique to avoid a possible underpayment penalty, where you make estimated tax payments of at least 100% (or 110% if the AGI was in excess of $150,000 for the prior year) of the actual tax liability for the prior year.
To avoid overpayment (thus giving the government a free loan and decreasing your cash flow), you may file an amended W-4 form and claim additional withholding allowances. Specific requirements must be met to do this, such as having large itemized deductions, tax credits, or alimony payments.
Accounting periods and payment dates
Most individuals use the calendar year accounting period, which is a 12-month period that ends on the last day of December. The other accounting period you may use is the fiscal year – a 12-month period ending on the last day of any month except December. There are rigid requirements for using the fiscal year accounting period, and the option to use it will be revoked if there are any filing errors. If you use the calendar year accounting period, your quarterly payments are due in four installments on:
- April 15
- June 15
- September 15
- January 15 of the following year
Use federal Form 1040-ES to determine the amount of your estimated taxes. This form, along with accompanying payment slips, can be obtained from the IRS. Once you order and use the form during a year, it automatically will be sent to you in following years.
If you also receive salaries and/or wages in addition to your self-employed income, you can avoid having to make estimated tax payments by asking your employer to withhold more tax from your earnings. You must file Form W-4 with your employer to arrange this.
Set up a special tax savings account
Avoid last minute panic! Deduct a fixed percentage from each check you receive and deposit it in a special tax savings account so it will be there when you need it. To calculate an approximation of what that percentage deduction should be, refer to the percentage of your total gross income that was owed as tax for the prior year. If you expect to make significantly more this year than last, you may be in a higher tax bracket. In this case, deduct a higher percentage out of each check so that you will have enough when estimated payment time comes around.
Resist the temptation to dip into this special account. If borrowing from this account is unavoidable, keep a record of exactly how much money you withdrew, and pay it back as soon as possible.
IRS: (800) 829-1040
Recorded information on more than 100 tax topics: (800) 829-4477
General IRS website: www.irs.gov
IRS website for the small business community: www.irs.gov/businesses/small/index.html
To order Publication 454 Your Business Tax Kit, containing an assortment of IRS forms and publications: (800) 829-3676
US Small Business Administration for publications on small business topics: (800) 827-5722
Small Business Development Centers for workshop and counseling website: www.sba.gov/sbdc. Check local listings for telephone numbers.
Service Corps of Retired Executives (SCORE) and Active Corps of Executives (ACE) for small business counseling and advice. Check local listings for telephone numbers.