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Setting money aside for taxes can feel like a foreign concept to freelancers. As an employee, your employer covered the majority of your tax burden, while the rest was removed from your paycheck. But as a self-employed contractor, you need to take care of your taxes yourself.
How to Understand Your Tax Burden
Freelancers, sole-proprietors, and single-member LLC owners are considered self-employed and must use the self-employment tax rate of 15.3% when filing. This rate is broken into two parts: Social Security (12.4%) and Medicare (2.9%). This is similar to employee FICA taxes.
Independent contractors also have to pay income tax, which is based on the amount they earn. For example, if you’re an independent contractor that makes $94,000 per year, you’ll have to pay $14,751 (from the other tax brackets) plus 24% on the excess over $86,375 for 2021.
How to Estimate Your 1099 Taxes
To estimate your tax burden, you can add your income tax bracket plus your self-employment tax rate and subtract that percentage from your income. If you made $94,000, your tax burden would be $30,963 ($14,382 + $16,581) or approximately 40% of your total income.
You can also use Keeper Taxes free 1099 tax calculator to understand your total tax burden throughout the year, should it change. KeeperTax can also confirm if you need to make quarterly payments, which occur if your business has to pay more than $1,000 in taxes a year.
How to Estimate Your Quarterly Tax Payments
The IRS expects you to pay quarterly taxes if your tax liability exceeds $1,000 per year. Keep in mind that the IRS won’t tell you to make these payments until after you incur interest. It’s essential to keep up with your bookkeeping so you know when these payments are necessary.
To estimate your quarterly tax payments, add up your total tax liability for the year prior and divide that number by four. The IRS will accept overpayments, but not underpayments, even if you make up for it on the next quarterly payment. Ask a tax expert if you need more help.
How to Estimate Your Deductions and Payments
Self-employed individuals can take advantage of dozens of deductions that help them reduce their tax burden. For example, people who work out of a home office can subtract a portion of their office expenses, utility bills, and rent/mortgage payments up to a certain percentage.
What’s more, freelancers can pay into their retirement savings plans to put themselves in a lower tax bracket. If you put $20,000 into your 401(k), that’s $20,000 that won’t be taxed until you remove it from your account. This can encourage freelancers to save for retirement.
How to Budget For Your Self-Employment Taxes
As a rule, most freelancers will put away 25-30% of their income in a separate account, but that may not be enough. Remember that saving too much is better than not budgeting enough, so it’s vital to put money away gradually to avoid audits or interest on missed payments.
To make the bookkeeping process easier, open a business account. Not only will two accounts help you keep your personal payments separate, but they’ll build valuable business habits.
What to Do if you Have a High Tax Burden
In the event that your tax burden becomes too high (40% or higher), you should consider registering your business. As an LLC, you can keep money held up in your business (if you have a separate business account), which lowers your self-employment tax burden significantly.
Freelancers can pay themselves by issuing an Owner’s Draw to take out only what they need to survive. This means only their “income” from the Owner’s Draw counts as personal income.