Should You Know About Income Tax Basics

We live in the post-recession economy. Along with more skepticism over the future of the economy, many have bought into the gig economy—where people take individual contract jobs rather than working for a larger company. Some might call it the American dream but if you don’t plan correctly, it could turn into something of a nightmare.

The Facts

A study by authors from Princeton and Harvard Universities found that the number of freelancers grew from 10.1% in February of 2005 to 15.8% in late 2015. Computer jobs hold the most freelancers but customer service, medical, and writing industries attract many as well. Freelancers beware—you might be setting yourself up for financial turmoil if you don’t think of yourself as a business owner. It has to do with taxes.

Taxes

As a freelancer you have to pay taxes just as you would if you worked for a larger company but with one important caveat. You’re responsible for all of the taxes. What you may not know is that when you are an employee, your employer pays half of your total Social Security and Medicare taxes. Thus, as an employee of someone else’s business, you paid 6.2% of your salary (up to the taxable maximum) for Social Security tax, and a 1.45% Medicare tax, (combined total, 7.65%.) Your employer was required to match those payments. Thus, your total contribution for Social Security and Medicare (your payment plus the employer’s) was 15.3%. And, of course, you also had money withheld from your paycheck for income taxes calculated based on the information you provided your employer on a W-4 form. As a freelancer, you have to pay both parts of the Social Security and Medicare taxes. Instead of paying the government your income tax plus 7.65% (combined Social Security and Medicare tax), you pay income tax plus 15.3% (minus any deductions or credits) That 15.3% is called a self-employment tax.

Determining the total amount of income tax, Social Security and Medicare taxes you’ll owe for the year isn’t easy. You have to take into account your income, your tax bracket, deductions, and credits. If your business is relatively stable, simply look at last year’s tax return and take numbers from there. Or, a very rough estimate is to take 35% of every dollar you make, put it in a separate account and use it to pay taxes. If you are required to pay state and city income taxes, don’t forget to calculate their cost for the year, too.

Tip: When determining the rates you charge your customers, don’t forget about those extra taxes you’ll owe. Too many freelancers don’t charge enough for their services because they don’t take taxes into account.

Estimated Taxes

The IRS isn’t going to allow you to hold onto the money you owe them until tax time. In most cases if you will owe more than $1,000 in taxes at the end of the year, you have to make quarterly estimated tax payments. If you file as a corporation, your threshold is $500 but most freelancers should pay attention to the $1,000 number.

How Much Should I Pay?

If you owe estimated taxes, how do you know how much to pay? If you use tax preparation software like TurboTax, it will tell you what it believes your estimated taxes will be based on your previous year’s tax return. The IRS also has forms and worksheets to help you. Aim for 100% of your previous year’s taxes or 110% if you will earn more than $150,000.

Estimated taxes are due quarterly—April 15, June 15, September 15, and January 15 of the following year. There are exceptions to these dates but you would almost certainly have an accountant advising you of those dates if that was the case. Be sure you pay your estimated taxes on time. If you don’t, the IRS will charge you a penalty.

If you don’t want to pay your taxes in 4 quarterly installments, there are a few other ways. First, if you receive a refund on your taxes, apply it to your estimated taxes. Second, if you or your spouse are employed by other companies, you can ask your employer to withhold additional taxes from your paycheck each week. (You’ll need to file a new W4 and fill in line 6 to indicate the additional amount you want withheld.) To come up with the amount to withhold, divide your estimated tax by the number of paychecks you will receive and have them without that amount. For example, if you plan to have a tax liability of $7,000 but you get paid from an employer once per month, have them withhold and extra $583.34 from each paycheck.

Learn more about estimated taxes at the IRS website.

Deductions

The great thing about owning a business is that your expenses are deductible. Nearly every purchase you make that directly goes to the operation of your business will reduce your taxable income. Everything from office supplies, to mileage, to the use of a home office will land you deductions and reduce your tax burden. Beware—you don’t want to exaggerate or take deductions you can’t prove. If you’re audited, the IRS will ask for receipts and substantiation of all of your deductions. Learn more here.

Employees

First, let’s be careful with that word. An employee is somebody on your payroll. You have to withhold taxes and even pay part of their tax burden. Remember the self employment tax above? You have to pay it. When possible, freelancers prefer to hire contractors (other freelancers) because the employer doesn’t have to worry about the taxes. It all falls on the contractor.