If you’re employed in a traditional sense, your employer handles the withholding and payment of your income taxes through payroll taxes. When you work for yourself, payroll taxes aren’t withheld from your earnings. To compensate for this, the Internal Revenue Service requires you to pay income taxes on all income and the self-employment tax if you earn income as an independent contractor. Because taxes aren’t withheld from your earnings, it’s essential that you set aside portions of your earnings to cover your tax obligation.
You’re required to pay self-employment taxes if you earn $400 or more from your own business activities. For the 2010 tax year, you’re liable for a 15.3 percent tax on all self-employment earnings less than $106,800; starting in 2011, that rate declines to 13.3 percent. Earnings that exceed $106,800 are taxed at a 2.9 percent both years. To calculate the amount you must save to cover your self-employment tax bill, multiply your net self-employment earnings by 0.153 each month, setting the funds in reserve for your year-end tax bill.
Income Tax and Estimated Payments
In addition to self-employment taxes, you also must claim income taxes on your self-employed earnings. Rather than pay this tax bill at the end of the year, the IRS requires you to pay income taxes on money as you earn it using estimated tax payments. Using tax charts appropriate to your earnings, you must estimate your year-end earnings and submit quarterly payments based on those projections. For example, if you earn $50,000 annually through self-employment income, your projected tax is $8,681.25 ($4,681.25 base + 0.25 * [50,000-34,000]). Every three months, you should pay a quarter of that total, or $2,170.25, in estimated payments.
If you fail to pay enough estimated income taxes throughout the year, you may face a penalty for underpayment. To avoid underpayment penalties, your estimated tax payments must total at least 90 percent of your actual tax bill, or be 100 percent of the prior year’s final tax. For example, if you paid a total tax of $4,000 last year, you must contribute an average of $1,000 in estimated payments each quarter to avoid penalties.
If you’re employed at a full- or part-time position in addition to your activities as an independent contractor, you may use payroll withholdings to defray your self-employment tax burden. Overpayment of FICA and income taxes on payroll taxes is credited toward your total tax bill. Submit a new W-4 to your employer instructing him to withhold additional income taxes each pay period. Depending upon your self-employed earnings, you may be able to adjust your full-time income to account for all income taxes and avoid the need to pay estimated taxes.