The Self Employed Vicious Tax Cycle
Let us lay out a scenario. You are a self employed individual. You are meeting with your tax accountant to complete your taxes by April 15 and are told that you owe a bundle in taxes for the year. In addition to the thousands you owe (that is due by April 15), your tax accountant advises you to also make your first estimated tax payment for the current year(also due April 15).
You simply do not have the money. You get set up on a payment plan to pay the balance due and because you are paying off this amount, you surely cannot make estimates for this year. At this rate, it feels as though you will never catch up. Does this sound familiar? Let’s talk about the vicious cycle of taxes and why estimated tax payments are important.
Estimated tax payments are due April 15, June 15, September 15, and January 15 (Note: The 4th quarter payment is due in the following year). Particularly, if you are a self employed individual, you should be making estimated tax payments. If you do not, with 100% certainty, you WILL owe every year. When you are self employed, your income has no withholding. You are on the hook for federal tax, state tax, but also self employment tax on this income.
To illustrate, think back to a time when you were a W-2 employee. Your actual pay was $2,000 but by the time you got your check, it felt like only a small portion was deposited in your account. The difference between your gross check and net check was a result of all those taxes are being taken out each paycheck. When you transition over to a position where you are getting a 1099, you are now considered self-employed and are responsible for paying these taxes on your own. This is a very important concept to understand.
We believe that proper planning starting in the beginning of the year can alleviate the illusion that you do not have the available funds to pay taxes at year end. I say illusion, because if your business is profitable, you did have the money at some point, you just spent it on something other than taxes. If you choose to put aside funds and pay as you go, you will never have such a large balance at year end. Being proactive and making the estimated payments will leave you from having a large amount due at year end, as well as help you to avoid associated underpayment penalties.
We attempt to explain this to clients before they get caught up in the vicious cycle. If you are already at the point where you are in the cycle, there is a way out. This will take planning and budgeting, but it will be worth it in the end. Please let us know if you have questions.