Bankrate.com spoke with Dr. Joe Webb, co-author of The Book, about the benefits of having a home office.
Tax season ended last month, to the relief of many (including CPAs, who can now take some time off and not have nightmares riven with images of voracious Schedule Cs), but at least two colleagues of mine have had some tax issues that a little advance planning could have avoided.
Well, okay, one hadn’t actually paid any taxes in about five years and finally got caught, so he really has no one to blame but himself for a five-figure tax bill (and should be happy it’s only five figures—and doesn’t come with a trip to Leavenworth).
As for the other, I had asked him, “Well, do you file estimated taxes quarterly?” to which he responded, “What’s that?”
Now, this is a person who has been a 1099’er for well over five years, and at the very least needs better tax advice than he has been getting.
In the book, we talk about tax planning and filing estimated taxes, but it’s worth taking a walk through the topic here, since it still remains a mystery to a lot of self-employed—even the long-term self-employed.
When you work full-time for a company, a certain amount is withheld from your paycheck, and as such it is called “withholding tax” (“withholding” being an adjective, not a verb, as in the case of my first colleague above…). Depending on the size of the company, withholding may be remitted to the IRS every pay period, or every quarter, or at some other interval. (When I worked for an individual, I was the only true full-time employee, and had to do my own payroll, so I got to see how this worked.) When you do your taxes in April, the form you get from your employer will indicate how much you had already paid throughout the year and, based on your adjusted gross income for the year, what you either owe or get back in April is the difference between what you paid and your overall tax liability. So if you paid too much over the course of the year, you get a refund. If you paid too little, you owe a bit more. Unless you have a variety of adjustments, deductions, supplementary or capital gains income, etc., usually the amount you owe or are refunded in April is fairly minimal.
This is all because, ultimately, the IRS would prefer that as much of your tax liability be paid in advance as possible. And, as we’ll see, it’s usually in your best interest to have that be the case, as well.
When you are self-employed—that is, are a 1099 employee, freelancer, or however you want to describe it—you are responsible for your own withholding. This is what is known as “estimated taxes,” which for most self-employed folks are filed quarterly (April 15, June 15, and September 15 of the current tax year, and in January 15 of the following year). How do you figure your estimated taxes? Well, a quick way would be to take your total tax liability for the previous tax year and divide by four to get a quarterly amount. This of course assumes that your tax liability will be the same year after year, which in turn assumes that a) your income will be the same, and/or b) your deductions will work out the same. In the latter case, that may or may not be true. If in Tax Year 1, you were establishing your business and had a lot of start-up costs, investment in office space, equipment, etc., you will likely not be repeating those expenses in Tax Year #2. So with the same income, you will have a higher tax liability. When doing your tax planning, start off by determining whether or not you will have any substantial capital investments. Some may be unforeseeable—your computer may die in August, you may need a major repair to your office space in June, you may land a client that requires a substantial piece of [something] you will have to invest in, etc. But often we can determine if a big-ticket item is going to be on the shopping list in the coming year.
As for income, that can be a little more difficult to gauge, especially if, like many freelancers, you don’t have a regular paycheck. So, when I described estimated taxes to my colleague, he scoffed and said, “How can I estimate my taxes? I have no idea what my income will be!”
Well, actually, you do have some idea of what your income will be, especially if you have had your business for more than one tax year. Simply use the previous year as a baseline, and track your monthly income. Keep a “year-to-date (YTD)” running total that compares last year and this year and, say, midway through the year, see what the differential is. If you are earning far more—or far less—from January–June 2014 than you did in January–June 2013, adjust your estimated payments accordingly.
Okay, so maybe you never tracked your monthly income before. No problem. Take the total amount you earned the previous tax year, and divide by 12 to figure out what, on average, you earned monthly. (If this isn’t handy, dig up your tax return.) Multiply that average monthly number by 6, and that will be your YTD figure for January–June.
So my colleague had also made the incorrect assumption that the amount he was socked with in April was some over-large tax burden, and was looking for ways of reducing it. Well, there are many ways of reducing one’s tax liability—although not necessarily on April 14—but the thing to remember is that whether you pay quarterly or in one lump in April, you will ultimately be paying about the same amount. The only difference is that in the former case, it will have been spread out over the course of the year. Think about it as if you got an electric bill annually rather than monthly. You’d have used the same amount of electricity no matter how often you paid your bill, but wouldn’t have to foot an enormous bill all in one fell swoop when you may not have the cashflow to pay it in one go. The same with your tax bill. It’s easier to pay smaller amounts each quarter than to write one huge check in April.
That said, sometimes we don’t have the cashflow for estimated payments. Sometimes we have clients who don’t pay in a timely manner, or who are having their own cashflow problems, so even though we know we will be making $X (or at least have invoiced it) by the end of the tax year, it hasn’t made it into our bank accounts yet when we need to file estimated tax payments. So we may need to skip a payment and double the estimated payment the next quarter.
Now, to keep track of income doesn’t require an elaborate MIS system; a simple Excel spreadsheet would suffice. Look at the figure below. Here, we have monthly income details for three years, plus half of 2014.
We assume for the first year (2011) that we did not track income monthly. So, the hypothetical businessperson took his or her annual income ($52,845) and divided by 12 to get an average monthly income of $4,403.75, then plugged this number into each month’s row. The Year-To-Date row calculates January to June for each year, and it is thus easy to see how 2014 stacks up against previous years.
To get the actual estimated tax amount, consult your tax accountant. If he or she is worth their salt, they will have told you at the beginning of the current tax year what you should pay quarterly, assuming your income doesn’t change substantially from the previous year. But, as you can see, it has, so it’s worth informing your accountant of this and adjusting your estimated payments accordingly. Even if you overcompensate (say, business tanks in the latter half of the year), the worst that will happen is you can re-adjust in Q3 or Q4 or, barring that, you’ll get a refund in April.
Bear in mind that if you are set up as an S Corporation or as any other type of entity, you may be using a payroll service like Paychex that can handle all of this. But if you are a strict freelancer/independent contractor, carefully tracking your income and diligently filing taxes quarterly can save a great deal of anxiety come tax season.
And if you have been avoiding taxes entirely…well, on your own head be it.