7 Ways To Avoid Self-Employed Tax Penalties

By Reyna Gobel AAA

When you're self-employed, you're required to send in quarterly estimated tax payments. But if your income varies from month to month or year to year, it's tough to determine the amount of taxes to pay each quarter. You don't want to send in so much that your daily expenses suffer, or too little that you get a shocking tax bill at tax return time - plus underpayment penalties that you can't afford.
If you follow at least one of these methods for calculating your quarterly estimated tax payments, you could minimize your chances of incurring penalties and of breaking your budget. (For more, check out 10 Tax Benefits For The Self-Employed.)

  1. Base Your Payments on Last Year's Earnings
    You can avoid paying a penalty by paying at least the same amount as you did last year - if you were self-employed. You can find the total taxes you paid on last year's tax return. To employ this strategy, divide last year's taxes into four equal payments and send them in by the IRS's quarterly due dates: April 15, June 15, September 15 and January 15. You will still be liable for differences in taxes between this year and the last, but you won't pay an underpayment penalty.

    For example, let's say you paid $4,000 in taxes last year. You send in four equal payments of $1,000 this year. You calculate your taxes at the end of this year at $5,500. You can send the IRS a check for the $1,500 difference without paying a penalty.

    You should note that if you weren't self-employed in the prior year, you won't incur a penalty for not making any payments before tax return time. You can choose how much to send in throughout the year, but beware that you could have a large tax bill at the end of the year if you don't send in enough. (For more, see The Simple Tax Math Of Roth Conversions.)

  2. Get Help When You Are First Self-Employed
    If you're not used to sending in your own tax money throughout the year, it helps to talk to a friend who's self-employed or hire an accountant to handle your taxes for you. They can help you figure out how much to pay and what to deduct to get the best, most accurate results. (See Crunch Numbers To Find The Ideal Accountant for more.)
  3. Use a Separate Credit Card or Checking Account for Business Expenses
    Have specific bank accounts or credit card accounts set up for your business expenses. This will help you when adding up the business expenses you are deducting from your income.

    Why is this easier than keeping receipts alone? Let's say you lose a receipt or two. You have to look through all your credit card and bank account statements to find the amount you need to add in with your total business expenses. However, if all transactions are in one or two bank or credit card accounts, you'll easily find your expenses when needed.

  4. Keep a Running Tally of Your Income
    You'll get sticker shock as to how much tax you owe at the end of the year if you don't keep a running tally of your income. Calculate your income at the end of each quarter and use this as a basis for whether you should recalculate your quarterly payments. Don't just rely on what you thought you were going to make at the beginning of the year.
  5. Use the IRS's 1040ES Worksheet to Estimate Payments
    The best way to estimate your quarterly payments if your income changes annually is to use the 1040ES worksheet available on the IRS website. This worksheet guides you through calculating your expected tax liability, taking into account certain deductions you may qualify to claim. You can fill out this worksheet again before each quarterly tax payment if your income changes.

    For instance, let's say at the beginning of the year, you estimate you will make $40,000 dollars. Thus, you are estimating you will pull in $10,000 per quarter. However, business picks up in the second quarter, and you now have reason to believe you'll earn $70,000 by the end of the year. You'll want to fill out the worksheet again, and subtract the amount you paid in the first quarter, then divide your remaining expected tax liability by three to determine your payments for the remaining three quarters.

  6. Always Overestimate Payments, At Least a Little
    Tax penalties can be pricey. Interest is charged on the amount you underpay from the day your quarterly payment is due until the day it's paid. The interest for the 2009 tax year varied from annualized rates of 5% to 6%, depending on the quarter. So if you underpay for the first quarter of a tax year, you could owe a different amount than if you underpaid for the third quarter. To avoid these penalties when you're unsure of the exact amount to pay each quarter, slightly overestimate your taxes. You won't lose any money. You'll get the money you overpaid back as a tax refund when you file your annual tax return.
  7. Put the IRS Tax Help Line on Speed Dial
    Especially if you are new to paying estimated taxes. The IRS free help line is your best source for answering any question you may have: 800-829-1040. (Check out How Do I Use The IRS Free File Tax Forms.)

Conclusion
When you're self-employed, unless you hire someone to do your taxes for you, you are your own accounting department. Try a few different methods for calculating estimated tax payments until you find the one that is best for you. In the meantime, get help with all questions you have. The cost for help could be as little as free from the IRS tax help line, while underpayment penalties aren't. (For further reading, checkout10 Most Overlooked Tax Deductions.)

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