Self-Employment, Estimated Tax, and Safe Harbor

By Pinyo, on September 17, 2008

Unlike my regular job, where my employer withhold a portion of my salary to pay various taxes — i.e., Federal, State, City, Social Security, and Medicare — there’s no tax withholding for my self-employment income.  To avoid any penalty, I have to pay self-employment tax and make estimated tax payments four times a year.  However, I didn’t pay any self-employment or estimated tax so far this year, but I should be okay due to an allowance made by the IRS.

About Self-Employment And Estimated Taxes

What Is Self-Employment Tax?

Self-employment tax is basically the Social Security and Medicare portion of your taxes.  When you work for someone else, these taxes are withheld on your behalf.  However, as a self-employed person, you’ll have to pay these taxes in addition to income tax. The self-employment tax rate is 15.3%, which consists of two parts: 12.4% for Social Security and 2.9% for Medicare.

What Is Estimated Tax?

Estimated tax is the method used to pay tax on your income that is not subject to withholding — i.e., income from self-employment, interest, dividends, alimony, rent, capital gains, etc. You also have to pay estimated tax if the amount being withheld is not sufficient to meet your tax obligation.  In general, you have to make estimated tax payments if you expect to owe $1,000 or more when you file your return.

Safe Harbor

However, the IRS is generous enough to make an allowance for people like you and me.  As long as you pay 100% of your previous year’s total tax liability in withholding and/or estimated taxes, you’ll be exempt from underpayment penalty regardless of your final tax amount.

My Tax Situation And How I Handled It

So far, this has been a stellar year for my web businesses.  In fact, I am expecting that my self-employment income will be close to 20% of my total income when the year is over.  I knew that I could take advantage of the safe harbor rule and made some adjustment to my W4 at the beginning of the year to withhold extra money per paycheck.  However, I am doing better than I thought and I am sure I didn’t withhold enough money.

The first thing I did was to estimate on my tax liability.  I did a quick search and found a nice free tax calculator by Tax Brain. The tool uses a 6-step wizard to guide me through a few questions about my income sources and deductions, then provides me with an estimate of my tax liability — it looks like I’ll owe Uncle Sam about $2,500.

Next, I adjusted my W4 to withhold extra money for the rest of the year for both Federal and City income taxes.  The extra amount won’t be enough to cover the entire $2,500, but it will be enough so that I won’t cringe when I see how much I owe.

In addition, I could open a SEP IRA to reduce my tax liability.  However, I still haven’t fully contributed to our Roth IRAs yet, so that where the money will go.  I doubt I will have any money left to open a SEP IRA account this year, but that could be something I could do next year.

Note that I am not a tax expert so do your own research! However, if you’re a tax expert and see anything wrong with my situation, please let me know ASAP!

Here are some articles about self-employment, estimated tax, and safe harbor rule:

• Self-Employment Taxes – Things You Must Know at Queercents
• Estimated Taxes, Safe Harbor, and AMT at Jeremy Zawodny
• Publication 505 (2/2008), Tax Withholding and Estimated Tax at the IRS
• Six Things You Must Know About Self-Employment Taxes at Web Worker Daily

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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