If you’ve recently started working for yourself and being part of the 57 million gig workers in the United States, you’ll know there are some changes you need to understand once you stop being an employee.
It’s great that you have the freedom that comes from working for yourself, setting your own hours and making your own choices. But once your revenue reaches a certain amount, you are going to have to start calculating your own income taxes.
Key differences between an independent contractor(1099) and W-2 full-time employee when it comes to paying taxes
Whether you’re a freelance writer, a web designer or an Uber driver and operating as a sole proprietor or independent contractor, understanding the different tax rate when you’re self-employed and working a 9 to 5 job will help you legally and financially. Below are key facts you should know:
You don’t have to worry about setting aside money for tax payments
If you are a full-time employee, the income tax withheld from wages usually covers your total income tax. Your employers already withhold your federal income tax, your state income tax and social security and medicare from your paycheck. So in this case, circumstances where doing estimated tax is not necessary. And when you’re filing your tax return at the end of the year, you’ll probably get a refund.
Type of form for tax filing
Employees receive a W-2 form at the year-end, showing income withheld by your employer and all income earned.
You manage your own system for paying taxes
As a gig economy worker, no one takes your money for taxes. You are responsible for calculating your taxable income on your own. That includes paying self-employment taxes which is essentially your medicare and social security. If you don’t set aside some money to pay for estimated tax, you’re probably going to owe the IRS a significant amount when you file your tax returns. And if you can’t pay it, you’re going to incur penalties.
Type of form for filing taxes
As an independent contractor, you’ll use form 1099 that will show how much clients paid you throughout the year. You should receive a 1099 form from each of your clients if you’ve earned at least $600 with them.
What is estimated tax?
Estimated taxes are quarterly payments made on the 15th April, 15th June, 15th September and 15th January the following year – based on your tax liability since an employer does not withhold your income. You need to pay both self-employment tax and income tax.
Usually, if you earn more than $400 in profit as a freelancer, you’re already required to pay taxes throughout the year. Or if you need to pay $1000 in total taxes at the end of the year, you need to pay your tax bill via quarterly estimated taxes.
Underpaying estimated tax during a given year will result in penalties. The federal government is going to assess interest on that tax which means you’re going to pay a lot more than if you paid the right amount.
Calculating estimated taxes
For most small business owners, figuring out how much you have to pay can be tricky, especially if it’s your first time making quarterly payments. You need to calculate your gross taxable income and work out any applicable deductions like your home offices’ rent or other business-related expenses, for example. Form 1040-ES has a worksheet to help you calculate the amount you need to make every quarter.
If you’re paying your estimated taxes based on last year’s tax return, use the 100% rule by using your total taxes number and dividing it by four. There’s also the 90% rule where you pay 90% of what you’re going to owe, and pay the difference when you file your tax return. The latter method is useful if your income fluctuates, and you want to keep more disposable income to yourself.
According to IRS’s tax laws, as long you’re paying 100% of your previous year taxes or 90% of the taxes you’ll be owing at the end of the year, you would not be penalized.
Various ways to pay quarterly estimated tax
See if you have made an overpayment on your previous tax returns
Instead of getting a refund, you can use some or all of the amount to pay for the first quarter of your next year’s tax liability. This saves you time and can be simpler than having to pay by other means.
Use a check or money order
Use quarterly payment vouchers that you need to print out. Then you can mail a check or money order payable to United States Treasury along with the voucher. The address that you should send this to is determined by which state you live in, and you can find the address within Form 1040-V which you can download at IRS’s website.
Deduct the amount from your bank account
Have it deducted from your bank account automatically using Electronic Funds Withdraw. You can do this up to four quarters and only if you electronically file your tax return.
Credit card payments
Credit and debit cards are accepted by phone or paying via irs.gov. There is a fee charged by the bank if using a credit or debit card. Using the IRS’ website takes less time and can seem more convenient, but you can only make one time payments. Direct payments can also be handled via your checking or savings accounts if you want to avoid the fees.
Paying via EFTPS
You can schedule all four quarterly payments, harder to set up but convenient in the long run. You need to create an account online and register your bank account.