How Much Money Should I Set Aside for Taxes as an Independent Contractor?
If this is your first time being self-employed, you’ve got a lot of things to think about. Although filing independent contractor taxes may not be on your short-list, you need to give it careful consideration.
Since you’re self-employed, there is no company that will withhold taxes from your paycheck and send it to the IRS on your behalf. If you have a net income after deductible expenses then you won't get a tax refund like an employee usually does. That means that if your business is making a profit in most cases, you will pay taxes.
But how much should you save for 1099 taxes? Our tax experts recommend 25-30% of what you earn from clients should save for tax obligations, and we’ll explain why.
What’s an Independent Contractor and Am I One?
An independent contractor is a fancy way of saying non-employee. When you complete work for someone but aren’t that person or business’s employee, you’re an independent contractor and are self-employed.
As an independent contractor, it’s best practice to have a written, signed agreement between you and your client. This agreement will protect both of you legally by defining the scope of the work to be completed and the nature of your relationship.
Clearly defining your relationship is important when it comes to the Internal Revenue Service. In recent years, the IRS has focused on auditing the employee/independent contractor arrangement. Although you may say in your agreement that you’re an independent contractor, the IRS has specific rules that govern whether someone is an employee or a contractor.
Tax Forms and the Independent Contractor
If you don’t form a legal entity like an LLC or a Corporation, the IRS will, by default, consider you a sole proprietor. This means you’ll use your social security number for all your tax documents. And this article will focus strictly on the sole proprietor.
When you begin working with a client, you’ll need to supply them with a Form W-9. This form provides your name, address, social security number, and tax classification. Note, if you formed a legal entity like an LLC, you should have applied for an employer identification number with the IRS. And in that case, you would use the name of your business and your employer identification number (EIN) instead of your social security number on the Form W-9.
If you’re paid more than $600 in a year by a client, they should but are not required to provide you with a Form 1099-NEC in January. This form replaces Form 1099-MISC that was used previously to report self employed freelancer and other non employee income.
The 1099-NEC will show how much you were paid, and any federal or state income tax that was withheld, if any. Usually, a client won’t withhold any income tax but there are a few exceptions for their required tax withholdings.
Since your client typically doesn’t withhold any tax from your payments, you’ll be responsible for making your federal and state tax payments to the IRS.
Taxes and the Independent Contractor
As an independent contractor, you’re responsible for paying your federal income, state and sometimes local taxes since you don’t have an employer do it for you. Be aware of California's new rules for being classified as a 1099 worker.
In addition to income tax, you’ll also be responsible for self-employment tax. And if you live in a state or city that has their own tax, you’ll need to pay those too.
The IRS likes to get their money on a regular basis. They don’t like waiting until April 15 for your tax payment. Known as a pay-as-you-go system, the IRS requires you to make regular payments to cover your tax bill.
Let’s look at a basic example to illustrate this. Assume you were an employee earning $80,000 per year and were in the 22% income tax bracket, you would roughly owe $17,600 ($80,000 x 22%) in federal income tax on your $80,000 salary.
The IRS doesn’t want to wait until April 15 for you to send them their $17,600. That’s why your employer would withhold tax from your paychecks and send it to the IRS on your behalf.
Now imagine you’re self-employed, there is no business owner to withhold tax and there’s no paycheck to withhold from. Assuming you make $80,000 in a year being self-employed, you’ll need to send that $17,600 to the IRS periodically throughout the year.
This is where the concept of estimated tax payments comes from. In instances like this, the IRS requires to you make quarterly tax payments to pay-as-you-go. Failing to pay along the way comes with hefty penalties.
Our example is overly simplistic because it assumes you’ll have no business expenses to deduct to reduce your $80,000 earnings. We’ll talk more about that later.
In addition to income tax, you’ll also have to pay self-employment tax rate of 15.3%. This includes the employer and employee portion of FICA taxes. This stands for the Federal Insurance Contributions Act, which includes Social Security and Medicare taxes.
Like in our example above where you’re an employee earning $80,000 per year, your employer would withhold from your paychecks 6.2% for Social Security and 1.45% for Medicare health insurance taxes. In total, you’d have $6,120 ($80,000 x 7.65%) withheld from your paychecks.
And your employer is required to kick in the same 6.2% and 1.45%. When you add that all up, you get 15.3% (6.2 + 6.2 + 1.45 + 1.45). And your employer would be responsible for sending both on to the IRS.
When there are no employee paychecks to withhold from and no employer to pay the employer’s portion of the Social Security and Medicare taxes, the responsibility falls on you. That makes you liable for the entire 15.3%.
Note that there are annual wage limits for the Social Security tax. For 2020, the limit is $137,770. Any earnings over $137,700 are not subject to the Social Security tax. There is no wage limit for the Medicare tax. But there is an Additional Medicare tax of 0.9% for all earnings above $200,000 in a year.
Thankfully, you’ll receive a tax deduction for the employer’s portion of the self-employment tax. That means when you file your tax return you’ll only owe 7.65% just like if you were an employee. To see how much you'll owe in taxes, use this online self-employment tax calculator.
Save 25 - 30% for taxes
Now that you know you’ll be on the hook for both your federal income tax and the employee portion of FICA, a generally safe estimate is to save 25 - 30% of your earnings to cover taxes.
Unless you’re earning more than approximately $160,000 per year, you’ll be in the 24% tax bracket or lower. Adding the 7.65% for Social Security and Medicare, you’ll be at a maximum of 31.65% (24% + 7.65%).
This is a simplistic and conservative method of calculating your estimated taxes. But it will ensure you don’t have a hefty tax bill come April 15. Keeper tax has a fantastic free quarterly tax calculator that will give you an estimate on what you will owe come tax time.
Consider Business Deductions
If you want to get a more realistic picture of your tax liability, you’ll need to file a Schedule C form for your deductible business expenses.
If you receive $100,000 in total income from your clients, that doesn’t mean you’ll pay taxes on that amount.
You’ll be able to deduct ordinary and necessary business expenses from that amount. Keep track of expenses like office supplies, postage, software purchases, and mileage. These expenses will help to reduce your taxable income.
Estimated Tax Payments
The IRS will require you to make estimated tax payments if you expect to owe at least $1,000 when you file your tax return.
Estimated tax payments are due on April 15, July 15, September 15, and January 15 of the following year. The IRS allows you to pay your entire estimated tax for last year on April 15, but you also have the option to spread it out equally over the four quarters. Here are instructions on how to file quarterly taxes.
You will avoid paying a penalty so long as your estimated tax payments are made on time and equal either:
90% of the total tax due for the current tax year or
100% of the total tax due for the previous year.
Remember that your estimated payment is based on your net income, which is the profit after deductible expenses. You’ll send IRS Form 1040-ES, along with your check. They allow several electronic payment options as well.
How to Save For Your Tax Payments
Since you may be required to make quarterly estimated tax payments, you’ll want to set aside money on a regular basis.
One way to do this is to set up a separate savings account for tax purposes. With each payment, you receive from a client, transfer a percentage of it to your tax savings bank account. When the time comes to make an estimated payment, you’ll use the money you set aside.
If you don’t want to think about how much you should pay for your estimated payments, use a free quarterly tax calculator to make the calculations for you. This will make your life as an independent contractor or small business owner way easier.