How to Estimate Taxes if You Are Self-Employed in 4 Steps
In the United States, the federal income tax system is pay as you go. Not paying as you go generally leads to income tax penalties. Paying federal taxes throughout the year is taken care of through two primary ways:
- Withholding from a paycheck or other income source.
- Pay estimated quarterly tax payments.
Generally, a larger majority of individuals use the paycheck withholding option because they receive W2 income. W2 income has withholding taken care when a W4 is filed or updated with an employer. However, due to side hustle incomes, large bonus payouts, or equity compensation, this withholding might need to be adjusted from time to time and may not prove sufficient for meeting your tax obligation.
For self-employed individuals/business owners or those who receive 1099 income as an independent contractor, estimated quarterly payments are a method of paying taxes throughout the year. It’s the self-employed individuals and 1099 independent contractor’s responsibility for calculating and paying their estimated tax. Thus, it’s critical to understand how to compute these taxes to prevent overpaying or underpaying and maximize your wealth.
In this article, you will understand how to do an easy four-step calculation of estimated tax payments and provide you the necessary tools for making estimated tax payments easily. Remember, the numbers will have to be adjusted to reflect your specific income situation.
Step 1: Estimate Taxable Income
Using the simplest definition, Taxable Income = Adjusted Gross Income (AGI) – Below-the-Line Deductions. Below-the-Line Deductions are either the standard deduction or itemized deductions, whichever is greater. Estimating your Taxable Income will make more sense with the following example.
Meet Rachel. Rachel is an entrepreneur and owner of a single-member LLC. Rachel projects to earn $100,000 in net earnings this year. Net earnings are after all business-related expenses. While there’s always a chance of income changing, having a starting point like this proves valuable. To project income, use your previous years earnings as a baseline to generate a reasonable forecasted income. If you are just starting a business or contract work, make your best earnings estimate and start there.
In addition to income, Rachel has two above-the-line deductions that will reduce her AGI. First, she plans to make a maximum $6,000 IRA contribution. Second, she will deduct ½ of her self-employment tax. This is a deduction for self-employed individuals, and we calculate this deduction in step two, which will make more sense.
We now have Rachel’s estimated AGI for 2022. To calculate her Taxable Income, we will assume Rachel is a single filer in 2022 and take the standard deduction of $12,950.
Rachel’s Taxable Income projection for 2022 is $73,985.23.
Step 2: Calculate Self-Employment Tax
The self-employment tax can be a surprise to entrepreneurs or 1099 independent contractors. This tax consists of both sides of the Social Security and Medicare tax. The difference between an employee who earns W2 income and a self-employed individual is as an employee, the employee pays only half of the Social Security and Medicare tax. The employer pays the other half. As a self-employed individual, you pay both parts because you are the employee and employer.
To calculate self-employment tax, we take Rachel’s estimated net income of $100,000 and multiply it by 92.35%. Only 92.35% of net income is subject to self-employment tax to adjust for being self-employed. For Rachel, this equals $92,350. Multiply $92,350 by the self-employment tax of 15.3%, and we get a tax of $14,129.55 (half of this is the deduction referred to in step 1).
On the self-employment tax:
- Social Security tax is 12.4% + 2.9% for Medicare = 15.3%
- The Social Security wage base in 2022 is $147,000 per person. Social Security is paid on earnings up to this amount.
- The Medicare tax of 2.9% applies to earnings up to $200,000 (individual/HOH), $250,000 (married filing jointly), or $125,000 (married filing separate) and increases by 0.90% for total of 3.8% without limit.
Step 3: Calculate Income Tax
Referring to step 1, Rachel’s Taxable Income is $73,985.23. This amount goes through the federal tax brackets to figure the federal tax liability. If you do not have tax software or a professional, you can estimate on your own using this tax bracket reference and rate breakdown. Rachel has income in the 10%, 12%, and 22% federal tax brackets, which are broken down below:
Rachel is in the 22% marginal tax bracket, but her income goes through the 10% and 12% bracket first. Her estimated income tax is $4,807.50 (tax due through the 12% bracket) + $7,086.25 (tax due in the 22% bracket) = $11,893.75.
Step 4: Add Self-Employment and Income Tax and Calculate Estimated Payments
We can now put together steps 2 and 3 to calculate the estimated tax for Rachel and quarterly estimates. Rachel is expected to have $14,129.55 in self-employment tax and $11,893.75 in federal income tax. Both taxes added together equals $26,023.30. Divide by four and we get Rachel’s quarterly tax estimate of $6,505.82.
With Rachel’s income on target with our projection, she can make these four estimated payments by the quarterly due dates to avoid the overpayment or underpayment or paying penalties. Reminder, these are estimated taxes, not “exact” taxes. If Rachel’s income increases or decreases dramatically, it’s important to re-calculate the projection and adjust estimated taxes.
In summary, here is the breakdown of the step-by-step calculation:
- If you have income as a W2 employee or spouse with W2 income, be sure to include those tax withholdings and income when calculating total tax and estimated payments.
- There is a safe harbor provision allowed by the IRS to avoid penalties by paying 100% of the previous year tax bill via quarterly payments. This can simplify your process but can lead to significant over/under withholding.
- The calculation we covered is only for federal income taxes. If you live in a state with state income tax, include state tax with your estimates. Then, verify with your state how to make payments.
- The final estimated tax payment for the previous year is due January 15th. Extending the deadline after the end of the year gives added flexibility to shore up the final tax payment based on tax paid and income received for the year.
- The Qualified Business Income Deduction (QBI) was not factored in for simplicity. This deduction applies to many self-employed individuals and entrepreneurs but has limitations for higher earners. Ensure this is included in by your financial or tax professional.
- For LLC’s taxed as an S corp, the estimated tax calculation will be different. The tax from salaries from an S corp are generally taken care of through payroll withholding. Profit distributions are not subject to self-employment tax, but quarterly payments may be necessary.
Estimated Tax Due Dates:
The final item to mention in this discussion is when estimated federal taxes are due. Below are those due dates for each quarter:
Calculating estimated tax payments does not have to be challenging. Even though they are estimates, the more accurately you can project your income and total tax bill, the less likely you will be surprised with an unwanted tax liability or penalty.
Being a business owner or entrepreneur means juggling many tasks. Let’s start a conversation about your financial and tax plan so you can feel confident and keep your attention on your business.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.