Being the boss brings a whole new set of responsibilities, and one you'll absolutely need to get a handle on is self-employment tax rules. Now, we know this doesn't sound as fun or interesting as the many other boss things you could be doing, but it's essential that you know your ins and outs ASAP.
Why? Having a general idea of how to calculate self-employment tax will help you as you move through the year and assist in forecasting how self-employment tax withholding might affect your cash flow and profits.
Whether you're filing taxes as an independent contractor or as a new business owner, you'll want to consider enlisting the help of a certified tax professional. They can help you to make sense of self-employment tax amounts and how the federal income tax rates for self-employed entities determine those amounts.
Of course, a little self-education never hurts and understanding how the process works can help you stay on the same page with an accountant. Let's dive in.
What is tax withholding? How does it affect self-employment?
You've likely worked for someone else in the past, so you're undoubtedly familiar with how tax withholding impacted your paycheck.
Your former employer deducts amounts from your gross wages or salary each pay period. Then, the company remitted those dollars to federal, state and local revenue agencies to fulfill your obligations.
At year's end and up to April 15th (or whenever tax day is scheduled), you'd receive a W-2, which summarized those deductions and created a report by which you'd calculate if you owed money or could expect a refund from the IRS.
Now that you're in business for yourself, self-employment tax rules take on a different form and filing process. Essentially, you're your own employer, and you're the one minding the tax withholding shop if you will.
What is estimated tax?
It's been said that there are only two certainties in life — death and taxes — and neither of them is avoidable. Thus, strategically planning for what you will ultimately owe to the federal government at year-end makes good fiscal sense from a couple of angles.
Self-employed quarterly tax payments allow you to make four payments throughout the year rather than forking over a big bundle of cash when a final tax return is due. Naturally, your revenue may change from year to year, so the best practice you can adopt is to estimate your self-employment tax payments based on past earnings and perhaps add a cushion for potential revenue growth.
On the other side of the equation, you also have a right to apply small business tax deductions against gross revenues, and a little foresight can make the difference between a big tax bill and a reasonable one. You will have the right to take advantage of small business tax deductions, so most expenses incurred in your business pursuits will reduce your taxable income.
As the year progresses, you may determine, through self-analysis or a consultation with your accountant, that an investment in the business may help boost your competitive advantage and reduce your taxable income. For example, purchasing a piece of capital equipment or vehicle toward the end of the year, if feasible, will provide you with a considerable tax deduction and a potentially smaller tax payment to the IRS.
How to calculate estimated tax payments
Calculating estimated tax payments isn't an exact science, but you want to get it right because you could incur an IRS penalty for underpaying self-employment tax estimated payments.
The best practice to adopt is following the guidelines a tax professional sets — or the amounts generated by tax-filing software — if you complete your tax return.
The easiest way to figure out how much you might want to pay throughout the year is by looking back on the previous year. This will be your best benchmark for calculating a self-employed tax amount. Along with self-employed federal tax rates that range from 10% through 37%, be sure to account for Social Security and Medicare taxes combined that amount to 15.3% of net income for 2022.
Note: deadlines for estimated payments fall on April 15th, June 15th, September 15th, and on January 15th of the following calendar year.
Let's assume you had to pay $24,000 in the previous tax year or $6,000 four times throughout the year. In this example, you'll want to set aside the same dollar amounts at a minimum to pay the IRS on those prescribed dates.
It's entirely possible that you may have a great year sales-wise, and your overall obligation will be $30,000 for the year. This will leave you with an additional $6,000 owed when filing a final business return and a possible underpayment penalty from the IRS. However, no penalty will apply if you match your estimated payments from the previous year.
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