Estimated Taxes for Freelancers, part 1

Early this week, I posted some information about budgeting for your business taxes, and Jennifer Rowland left the following comment:

Could you do a follow-up article on quarterlies? A lot of new and accidental freelancers would appreciate some info about when you need to pay quarterlies, how you do it, when you need professional advice from a business banker or an accountant–that sort of thing.

I agree, Jennifer. When I first got into freelancing, I had no idea what I was doing. Lucky, the person I was dating at the time is a CPA! Since tax laws change ALL the time and laws vary from state to state (and DEFINITELY from country to country), I do recommend talking to your own accountant as well. And please, if you are an accountant, and I’ve made a mistake, feel free to correct me!

Image via sxc.hu.

What are estimated taxes?

When you’re on staff somewhere, taxes are taken out with every paycheck if the government didn’t do that, they’d get huge lump sum payments in April instead of smaller payments four times a year. For a freelancer, no taxes are taken out of the money you earn. Therefore, you have to pay them in yourselves – and the government wants you to do so four times a year instead of in one lump sum. These are called “estimated taxes” because you’re estimating how much you’ll make for the year, based on last year’s income, and splitting the percentage owed into quarters.

Do I have to pay estimated taxes?

Let’s assume that you haven’t withheld anything (more on that in a minute). Do you have to pay estimated taxes? If you earn money freelancing, they yes – but there is an exception to the rule. If your total income is small enough that you’ll end up paying less than $1000 in taxes, you don’t have to pay them quarterly as estimated taxes. Instead, you can just pay them in a lump sum at the end of the year.

You also may not have to pay estimated taxes if you withheld money last April. For example, say you had a 9 to 5 office job and were scheduled to get a refund because you overpaid taxes throughout the year when they were taken out of your salary. When that happens, you can opt to NOT take the refund, and instead keep the money in the system. There’s really no reason to do this, since you don’t get interest or anything, unless you foresee freelancing or business ownership next year. If the money you withheld is at least 90% of what you’ll owe, you don’t have to pay estimated taxes – in essence, you’ve already paid them.

There’s also something called the “prior year safe harbor.” Let’s say that you earned $30,000 freelancing last year and also had a part-time job. You had some money in the system already, since you opted not to get a refund from the taxes due from your part-time job. This year, you were on track to make around that same amount, so it looked like you had enough money in the system to pay for your freelance taxes, when suddenly you sold a ton of ebooks in December. You ended up making $40,000 instead – and owing a lot more in taxes. It isn’t really fair to penalize you for not paying estimated taxes, since you couldn’t have predicted the huge growth. The “prior year safe harbor” rule says that as long as you’ve paid in at least 100% of what you owed last year, you won’t be penalized even if you make a ton more money. Keep in mind that you still have to pay taxes on that full amount you’ve made – but you can pay it in a lump sum in April.

Part 2 will be posted tomorrow, and part 3 on Wednesday! We’ll cover:

• When do I pay estimated taxes?
• How much should I pay in estimated taxes?
• What about social security?
• What happens if I don’t pay estimated taxes?
• What forms do I need?
• Where do I send the check/forms?
• Can/should I pay early if possible?
• Do I have to pay taxes if am just doing this as a hobby?
• Should I hire an accountant?