Now that you're an independent contractor, you won't have any taxes withheld from your pay -- so your take-home pay will be substantially higher than that of an employee who earns a similar amount.
However, self-employed workers still have to pay taxes, just like everyone else. And they don't have the luxury of waiting until April 15 to pay all of their taxes for the previous year -- the IRS wants its money faster than that. Independent contractors have to pay tax on their estimated annual income in four payments, spread out over each year. These payments are called estimated taxes and are used to cover income taxes and self-employment taxes (Social Security and Medicare taxes).
Because of this estimated tax requirement, you need to budget your money carefully. If you don't set aside enough of your earnings to pay your estimated taxes, you could face a huge tax bill on April 15, and possibly penalties for not paying estimated taxes. You might also have a tough time coming up with the money to cover the amount you owe.
Who Must Pay Estimated Taxes?
If, like the vast majority of self-employed people, you are a sole proprietor (that is, you own your own business), you have to pay estimated taxes if you expect to owe at least $1,000 in federal tax for the year.
However, if you didn't have to pay any taxes last year -- for example, because your business didn't make a profit or because you weren't working -- you don't have to pay any estimated tax this year, no matter what you earn. This rule applies only if you were a U.S. citizen or resident for the year and your tax return for the previous year covered the entire 12 months.
How Much Estimated Tax You Must Pay
You should figure out how much estimated tax to pay after completing your tax return for the previous year. Most people want to pay as little estimated tax as possible, so they can earn interest on their money instead of handing it over to the IRS. However, the IRS imposes penalties if you don't pay enough estimated tax. You can avoid these penalties by paying the lesser of:
- 90% of your total tax due for the current year, or
- 100% of the tax you paid the previous year (or possibly more, if you're a high-income taxpayer).
When to Pay Estimated Tax
You usually have to pay estimated tax in four installments, starting on April 15. However, you don't have to start making payments until you actually earn income. If you don't receive any income by March 31, you can skip the April 15 payment and make only three payments for the year, starting on June 15. If you don't receive any income by May 31, you can skip the June 15 payment as well, and so on.
Here are the due dates and periods covered for each installment payment:
|Income Received for the Period||Estimated Tax Due|
January 1 through March 31
April 1 through May 31
June 1 through August 31
September 1 through December 31
January 15 of next year
How to Make Your Estimated Tax Payments
The IRS wants to make it easy for you to hand over your money, so the mechanics of paying estimated taxes are simple. You file your federal estimated taxes using IRS Form 1040-ES. This form contains instructions and four numbered payment vouchers for you to send in with your payments.
If you did not pay estimated taxes last year, get a copy of Form 1040-ES from the IRS. You can get IRS forms by calling 800-TAX-FORM, visiting your local IRS office, or downloading them from the IRS website at www.irs.gov. After you make your first payment, the IRS should mail you a Form 1040-ES package with preprinted vouchers.
Penalties for Underpaying Your Estimated Taxes
The IRS imposes a fine if you underpay your estimated taxes. You have to pay the taxes due plus a percentage penalty for each day your estimated taxes went unpaid. This percentage is set by the IRS each year. In recent years, the penalty has ranged from 6% to 8% annually.
This penalty is only a bit higher than the interest you'd have to pay on borrowed money. Many self-employed people decide to pay the penalty at the end of the year rather than taking money out of their businesses during the year to pay estimated taxes. If you decide to follow their lead, make sure you pay all of the taxes you owe for the year by April 15 of the following year. If you don't, the IRS will tack on additional interest and penalties -- and quickly make it prohibitively expensive to pay late.
Want to Learn More?
For additional information about paying estimated taxes and other rules for independent contractors, get Working for Yourself: Law & Taxes for Independent Contractors, Freelancers & Consultants, by Stephen Fishman (Nolo).