When transitioning to self-employment, many people ask how they should go about paying in taxes for their earnings from self-employment. Let’s clarify that when I say self-employed, I mean you are a sole-proprietor for tax purposes. This means you either have no entity formed and are just operating under your name, or you have a single-member LLC that you did not make any tax-elections for (for example, you did not make an S-election to be treated like an S-corporation). If either of these situations match yours, then you will report your self-employment income on schedule C on your personal tax return every year.
As you start making money, you might be thinking, “I know the government is going to want my money, so how do I get it to them?” There are really two ways to go about this.
Option 1: Quarterly estimated tax payments
This is the pay-as-you-go option for self-employed individuals. You can pay your taxes for the current year in four equal installments to the IRS and to your state. These installments are generally due April 15th, June 15th, September 15th, and January 15th. You can pay these by check using form 1040-ES, which you can download from irs.gov, or you can pay online using Direct Pay via irs.gov. Most states also have options to pay online.
This option is the best way to avoid tax penalties. The IRS wants their money throughout the year. They don’t want to wait for you to file your taxes in April of the following year and pay then. If you do wait, you could end up paying penalties with your balance due in April. Here’s how it works. In 2020, you are required to pay in the lesser of 90% of your 2020 tax liability or 100% of your 2019 tax liability (110% if your adjusted gross income was over $150,000 in 2019). If you don’t meet either of these, you will pay penalties assuming your balance due on your tax return is over $1,000.
Since it’s difficult to know what your 2020 tax liability will be during 2020, I generally recommend paying in 100% of your prior year’s liability just to be safe. You can do this by taking the total tax figure from line 16 of your 2019 tax return and subtracting out any withholding you may have from W-2 jobs. Take the number that remains and divide it by four to figure out how much to pay in quarterly.
Option 2: Pay your taxes on April 15th
This option works best for individuals who are in their first year of self-employment and do not expect significant income from the activity. It is sort of a “wait and see” type of attitude. If the business does well, you’ll likely owe taxes come April 15th. If it is more of a side-job, you may be able to cover the additional taxes due with your withholding from your W-2 job.
Be careful with this option though, because as stated above, there may be tax penalties if your balance due is more than $1,000 and you don’t meet either exception to the underpayment penalty. Underpayment penalties are essentially like throwing your money in the garbage. Everyone pays income taxes, but underpayment penalties are totally unnecessary and usually a result of poor planning.
Planning can be difficult for self-employed individuals. It’s important to hire a good accountant (me) to make sure you are penalty-proof and not flushing your hard-earned money down the toilet.