When people talk about Tax Day, they’re often referring to the deadline to pay the previous year’s taxes. On April 18, this means paying taxes. But for the self-employed, it’s not just about the previous year’s taxes and, instead, also involves planning for next year’s taxes.
That’s why, for the self-employed, Tax Day isn’t just a national event. It’s the most expensive day of the year for most business owners, contractors, freelancers, solopreneurs or other self-employed operators. This fact is especially true, if your profits rose the year prior. That means you’re updating the amount of taxes you pay for the previous year, and also paying a higher estimated tax for the current year.
How do you prepare for such a day? Planning throughout the year plays a big role in reducing the headache felt come mid-April.
Planning for Taxes
The cause of the day of dread for the self-employed has to do with estimated taxes. As the year progresses, those working for themselves have to send the IRS tax payments based on what they made this year or the year prior. The first estimated tax payment lands on the same day as Tax Day.
It’s particularly problematic for those that have had a good year prior. Say you make $80,000 working for yourself. Well, for next year, you’ll pay estimated taxes based on you making $80,000. But then you make $100,000 instead. Come April 18, you have to pay the difference in taxes you owe from the estimated amount paid and the total tax liability you faced for the previous year.
That’s not all, though. Since you also have to pay first quarter estimated taxes for the new year, you then have to pay based on the improved performance (typically). This results in additional quarterly taxes than what you paid the year prior.
It’s a significant burden, one that can tap self-employment safety nets. Without those safety nets, it can result in returning to a standard job or make operating in the current year more difficult.
Strategies to Counter the Tax Concern
When people start down their self-employment journey, they often realize they need to pay taxes but don’t have a formal strategy in place. It can result in a huge tax bill come the first Tax Day.
More often than not though, business owners prepare slightly better by shifting one-third of any check received out of their main account to another checking account or bucket within an account to cover taxes.
Why one-third? It’s simple back of the napkin math. If you’re starting out the self-employment journey, it’s likely that you’ll reside under the 25% mark for income taxes. You’ll also owe self-employment taxes, which cover your Social Security and Medicare. Then add, depending on state taxes, what you might owe to your state of residence. This can often come under 33% tax rate, since you may make less during the first year of operations.
But it’s not guaranteed. And you may end up making more than expected. As you make more, it’s vital to add some dynamism to your tax planning.
Dynamic Tax Planning
When providing estimated taxes throughout the year, in order to avoid IRS penalties, you have to pay the lesser of 90% of the taxes you owe for the current year or 100% of taxes owed the previous year (110% if your adjusted gross income is above a certain level, which grows with inflation).
This rule allows you some flexibility in how you’re paying estimated taxes throughout the year. For instance, if you find that you’re suddenly making more throughout the year than expected, you can either ensure you pay the 100% from the previous year and use the extra cash flow for other tax reduction tactics, like saving for retirement.
Or, let’s say you’re making less this year. Then you can adjust down, based on what you need to cover for the year.
It allows adjustments throughout the year, and pinpoints a more clear estimation than the 33% plan.
It may also take some planning to ensure you’re close to the mark, in order to avoid fees.
But with this strategy, the tax day hit can be reduced. It may never become just a normal day. At least, though, it won’t become a day to fear.
