A Few Words on Estimated Taxes

We meet with many clients who are making the transition from employee to self-employed.  This is an incredible journey for most people.  Adjusting to taking on the expenses of the business, balancing work/life, and figuring out how to wear the many hats required of a small business owner are a few of the of the challenges new entrepreneurs face.  For many, the freedom of being your own boss and the joy of seeing your hard work and planning succeed make this path worthwhile.  However, one of the big areas where we see new entrepreneurs get stuck is taxes.

When you get a paycheck, the taxes are relatively easy.  You fill out a W-4 and the appropriate taxes are withheld on every paycheck.  When you are self-employed, that’s not the case.  Since you are the employer and the “employee”, you now pay both halves of the Social Security and Medicare taxes.  So you’re instantly paying more money.  Perhaps more importantly, if you don’t have the discipline to pay the taxes as you go or save appropriately, you’ll be in for a big surprise come tax time.

In most cases, the IRS requires payments to be made during the tax year.  If they are not made, the IRS will assess penalties once your return is filed.  To avoid these penalties you must send in quarterly payments.  Today we will look at the three basic methods for calculating estimated tax payments.

100% prior year

This is the most basic calculation.  Simply look for the line on your tax return that says “total tax” (Line 61 on Form 1040) for the previous year.  That is the amount that has to be paid in for the current year.  If you or your spouse has any withholding from other income sources, subtract that from the total tax figure.  The remaining balance should be paid in four quarterly installments.

90% current year

The first method is great if income is similar or even if it’s growing.  But what if your income will be dramatically reduced in the current year?  It doesn’t make sense to send IRS your money interest free and wait until sometime next year to get it back as a refund.  Instead, you can do a calculation for projected taxes due, and send that payment in over the four quarterly payments.  When you file the final tax return, if your estimated payments are within 10% of the actual total tax due, then you don’t have to worry about penalties.

Annualized Method

Lastly is a method that is perfect for businesses that are subject to seasonal swings of sales and cash flows, especially if that income is earned towards the end of the year.  Rather than paying evenly when it may cause a hardship, the annualized method actually lets you calculate real earnings at different periods during the year, and then recomputes the estimated payment for each quarter based on your business’ performance.  This is the best method to tie payments to actual results, but it is also the most time consuming and involved to calculate.

Generally speaking, as long as you are using one of the above methods, you should be in pretty good shape.  Many entrepreneurs don’t think of them as such, but taxes are a very real business expense.  In the same way that you cannot expect to succeed if you are not paying vendors, you will not succeed if you are not paying IRS.  And having a proper understanding of the impact of taxes both on your over profitability and cash flow is critical to making a successful transition to be self-employed.