Personal Finance Essentials
Taxes for the Self-Employed
The IRS Doesn’t Send Reminders
When You’re Self-Employed, Taxes Are Your Job — Here’s How to Do It Right
Quarterly Estimated Tax Payments
When you work for an employer, income taxes are withheld from each paycheck and sent to the IRS on your behalf. When you’re self-employed, no one does that for you. You are responsible for paying your taxes as you earn your income — and if you don’t, you can face penalties and interest charges on top of what you already owe.
Self-employed individuals are generally required to make estimated tax payments four times per year. If your estimated annual tax liability is $10,000, for example, you would typically make four quarterly payments of $2,500 each. Waiting until the fourth quarter to pay the full amount isn’t allowed. The IRS calls this an “underpayment” and will penalize you for it.
For business owners whose income fluctuates significantly throughout the year — a ski shop owner who does most business in winter, for example — there’s a tool called the “annualized method” that allows you to calculate each quarterly payment based on the income actually earned during that specific quarter. This prevents you from overpaying or underpaying in any given quarter based on seasonal swings.
The Home Office Deduction
If you use a portion of your home exclusively for business, and if you conduct substantial administrative or management activities there, you may be entitled to a home office tax deduction. This deduction allows you to allocate a proportionate share of your home expenses — mortgage interest, utilities, insurance and depreciation — to your business.
One important caution: if you ever take the home office deduction, you may lose eligibility for the full capital gains exclusion when you sell your home. The portion of your home that was treated as a business office could be subject to capital gains tax at the time of sale. This is a real tax trap that catches many home-based business owners off guard. Consult a tax professional before claiming this deduction.
SEP Contributions and Your Tax Bill
Contributions to a SEP-IRA are treated as a normal business expense and are deductible from your business’s gross revenue. This makes the SEP-IRA one of the most tax-efficient tools available to small business owners. Every dollar you contribute to a SEP directly reduces your net self-employment income, which in turn reduces both your income tax and your self-employment tax liability. The tax savings can be substantial, especially for higher earners.