Working as an independent contractor offers significant freedom, but if it’s your first year doing so, it can come with some serious headaches if you haven’t paid attention to your taxes. You’ll still file your taxes along with everyone else in April, but you’re now expected to make estimated quarterly payments, as well and save for all your taxes.
This is the largest initial difference that contractors experience when they first move away from traditional employment. Instead of your employer withholding payroll taxes and income taxes on your behalf, you are paid the entirety of your contracted pay – it’s now your responsibility to settle up your taxes.
This chart below shows the difference between the two:
Instead of receiving Form W2, like an employee, you’ll receive Form 1099 which will report every dollar paid to you in that calendar year from anyone that paid you over $600.
First, it’s important to understand that the IRS considers a 1099 worker to be self-employed. You do not pay employment taxes when you receive your income, but you will settle up employment taxes when you actually file your taxes.
So, in addition to income taxes, you are also responsible for self-employment taxes. In 2024, the rate is 15.3% on the first $168,600 of net profit, plus 2.9% of anything earned over that amount. The tax itself is for social security and medicare that traditional employees have withheld from their paycheck. As an employee, you only pay half of the 15.3% because your employer pays the other half. But as a self employed taxpayer, you have to pay both sides.
Earlier, we mentioned that you’ll likely be required to pay estimated taxes throughout the year. The IRS requires anyone that will expect to owe more than $1,000 in taxes for the year to do this or receive penalties.
Estimated quarterly taxes are generally due on the following dates:
In states that have a state income tax, you’ll be required to make state estimated payments, as well. They follow the same schedule as the federal payments.
The biggest problem 1099 workers face is taxes since it is not withheld for you like a normal W2 job. If you are or are going to be a 1099 worker, it is critical that you are paying attention to your income situation and what that means for your taxes. Ensure that you are saving enough to make estimated payments to any required taxing authorities. A lot of people throw out rules of thumb like save 20%, 30%, 40%, etc. but you can be wildly off by doing this. Work with a professional to estimate what your taxes will be based on different profit ranges so you do not have any major surprises. I have seen many people be off by $50k-$100k+ and that is not easy to get back on track.
Many people ask us “well can we just wait and pay taxes in April vs estimated payments?” And the answer is yes, but there are penalties associated with underpayment or missing estimated tax payments that are assessed when you make your tax filing. So we typically advise against that to avoid penalties.
It’s possible to avoid these penalties by doing one of the following:
There are a variety of resources available to self-employed individuals to help them calculate their taxes throughout the year. Turbotax and other sites offer free tax calculators that will help you narrow down your tax liability. Remember, you are not taxed on revenue, you are taxed on revenue – expenses – deductions you have.
Some deductions to keep in mind:
There are also deductions for use of a vehicle and use of a home office. There are separate calculations for each.
In general, any reasonable and ordinary expense that you incur in the normal course of business will be deductible on your Schedule C when you go to calculate your net profit at the end of the year.
First, as we discussed, it’s important to find the approximate percentage of tax each dollar you earn will accrue. From there, you have a couple of options.
Some people will move the proportion of tax that they will owe from each payment they receive to a savings account, as soon as they receive it. Others do this on a monthly basis.
Either way, you will want to make sure you have some system or schedule to move funds to save for taxes. Do not just think you will have the dollars later. And remember, make sure to go pay these quarterly taxes from your savings.
To wrap this up, I want to mention some other ways a self-employed individual can reduce their tax liability that goes beyond business expenses.
While W2 employees often have retirement plans available to them, self-employed individuals will have to set these accounts up on their own behalf.
Examples of the plans available to self-employed: SEP IRA, SIMPLE IRA, and Solo 401(k).
A SEP will allow you to contribute up to 25% of your net earnings from self-employment up to $69,000 in 2024. Your net compensation limits for determining contributions are $330,000 in 2023, and $345,000 in 2024. The contributions are deductible to you on your Schedule 1.
A SIMPLE IRA allows for a max contribution of $16,000 in 2024, plus an additional 2% fixed contribution or a 3% matching contribution. Your net compensation limits for determining contributions are $330,000 in 2023, and $345,000 in 2024. The contributions are deductible to you on your Schedule 1.
A Solo 401(k) (my favorite option) allows you to contribute up to 25% of your net earnings from self-employment to a maximum of $66,000, in 2023 and $69,000 in 2024. Your contributions are deductible on your Schedule 1.
The most important thing you’ll need to be aware of is your tax liability. Plan for taxes and treat the money that is subject to tax as if it’s not yours in the first place. Save yourself from an unmanageable tax bill when you file, so you can focus on your business and not add any IRS debt into the picture.
Thanks for reading and if you need help managing your self employment income and tax planning, hit us up! We are here to help.
Financial Advisor