Money earned from self-employment, freelancing or gig work is taxable, but if you’re operating as an independent contractor you can’t count on an employer to withhold taxes for you. You have to do so yourself by paying estimated taxes on a quarterly basis. Approximately 15 million Americans – or 10% of the workforce – were self-employed in 2015, the latest year for which the U.S. Bureau of Labor Statistics has data. With 55 million Americans working in a freelance role and an estimated 20% of adult workers doing paid informal work as part of the gig economy, this affects a lot of people.
Don’t Ignore Paying Estimated Taxes
While being self-employed, freelancing on the side or taking on the guise of a gig worker has its perks in terms of freedom and flexibility, there may be a financial downside. If you slip up and fail to pay enough in income tax, the Internal Revenue Service (IRS) could come knocking. (For more, see Estimated Taxes: Back to Basics.)
More Taxpayers Face Penalties for Underpaying Taxes
Between 2010 and 2015 the number of taxpayers facing penalties for underpayment of taxes increased nearly 40%, from 7.2 million to 10 million, according to figures from the 2015 and 2016 IRS Data Books. In 2015 the average penalty assessed against these taxpayers was about $130, a marked decline from the $210 average penalty for 2010.
There are several factors that could explain the surge in underpayments and the number of Americans being hit with penalties. An uptick in taxable-investment gains may be one culprit. The stock market has been on an overall steady climb since 2009, with 2017 seeing major indices such as the Dow Jones Industrial Average and the Standard & Poor 500 Index hitting record highs.
Required minimum distributions (RMDs) are another possible cause. By 2015 only a third of the oldest Baby Boomers were still working. If you’re retired and taking required minimum distributions, you may have to pay estimated taxes to cover any taxes owed on that income. If you don’t, you could trigger the underpayment penalty. You can get a break your first RMD year if your total tax owed is less than $1,000, but you’ll have to complete IRS Form 2210 to find out if you a penalty is due and how much it is.
What may be more likely to account for the shift, however, is the changing landscape of the American workforce. The number of freelancers, for example, increased by two million between 2014 and 2016. While some Americans may be freelancing as a side hustle in addition to a regular nine-to-five job, others are embracing it as a full-time occupation. (For more, see Start a Side Gig for Extra Cash and Fulfillment.)
In that scenario they’re 100% responsible for ensuring that they make their estimated tax payments. The same is true for individuals who are doing gig work online or setting themselves up as independent contractors with companies such as Lyft or Amazon (the latter uses gig workers in its Flex delivery service). If you’re new to self-employment, you may not understand the rules for filing and paying taxes on that income. Filling in that knowledge gap is critical for avoiding a tax penalty.
Avoiding Underlayment Penalties
If you’re self-employed or retired and taking RMDs from a retirement account, the first thing you need to know about estimated taxes are the due dates. Estimated taxes are due on April 15, June 15, Sept. 15 and Jan. 15 for the current tax year. Keep in mind that you still have to observe the April deadline for filing income taxes, as well as paying your estimated taxes.
Next know how to calculate your estimated tax due. You can do this using IRS Form 1040-ES or by running the numbers through an estimated tax calculator. To estimate your taxes due, you’ll need to know how much untaxed income you have for each quarter, so good recordkeeping is vital.
Finally, if you’re paying taxes through a regular job, be sure to check your withholding and compare what you’re paying to your estimated tax due. If your withholding covers your entire tax liability for the year, that can reduce or eliminate anything you’d have to pay in estimated taxes. On the other hand, if you come up short you may have to increase your withholding to lower the odds of being hit with an underpayment penalty.
The Bottom Line
Estimated taxes may take some getting used to if you’ve never had to deal with them before, but the sooner you get up to speed the better. If you’re worried about the IRS flagging your return, erring on the side of caution and overpaying estimated taxes could help ward off any penalties. On the bright side, you may be able to get some of that money back if you’re due a refund.