No one wants to think about taxes during the holiday season, but if you earn freelance income, acting now could save you money in the new year.
For most Americans, automatic tax withholding makes paying your taxes relatively painless. The same can’t be said if you’re one of the millions earning freelance income. If you have a side hustle, take on contract work or are self-employed, you’re required to pay estimated taxes on your earnings four times a year. Failing to pay enough in estimated taxes throughout the year can cost you — and that cost just got even more expensive.
Just as interest rates on savings and loan products have risen in lock-step with the Federal Reserve’s rate hikes over the past two years, the IRS has also raised the interest rates it charges for estimated tax underpayments. The underpayment penalty rate is now 8% for the fourth quarter of 2023, up from 3% in the first quarter of 2022.
“If you have made timely estimated tax payments/withholding and you owe less than $1,000, there is no interest as long as you pay the amount due by April 15th,” said Eric Bronnenkant, CPA, CFP and head of Tax at Betterment. However, if you’ve earned freelance income and haven’t made estimated tax payments or have underpaid, squaring up before the end of the year can help you minimize penalties.
What are estimated taxes and when are they due?
Estimated taxes are quarterly tax payments made by freelancers and business owners on income not subject to automatic tax withholding. If you receive money that isn’t taxed, it’s likely you’ll owe estimated taxes on it.
The IRS operates on a pay-as-you-go model, meaning you’re expected to pay taxes on income as you earn it throughout the year. For freelancers, this breaks down into four payments per year. The quarterly payment deadlines for 2023 were April 18, June 14 and Sept. 15. Your final quarterly payment is due by Jan. 16, 2024. You can make estimated tax payments online via Direct Pay with the IRS or by using a credit card or digital wallet.
Read more: What Are Estimated Taxes?
How to avoid IRS underpayment penalties
The best way to sidestep underpayment penalties is to make sure you pay enough in estimated taxes throughout the year. But that’s not always simple.
“For freelancers and those with side hustles, it’s sometimes challenging to estimate taxes accurately due to fluctuating income,” said Dana Ronald, president of Tax Crisis Institute. “Aim to pay at least 90% of the tax you’ll owe for the current year or 100% of the tax you paid the previous year, whichever is smaller. This can help you avoid penalties.”
The IRS may also waive underpayment penalties in certain situations. To look into having your fees waived, review the IRS underpayment guide to see if you qualify.
How to calculate what you’ll owe in estimated taxes
Figuring out your estimated taxes can be tricky, depending on your income level and how many clients you have. Most experts recommend setting aside at least 30% of your pay for taxes, but your specific rate will vary.
To calculate your freelance tax liability for the year, you’ll need to determine how much you owe in both estimated income tax and self-employment tax. You’ll also want to deduct any eligible business expenses. You can use an online tax calculator or IRS form 1040-ES, Estimated Tax for Individuals, to figure out how much you’ll owe.
If you also earn a paycheck from an employer that withholds taxes, you can use the IRS Tax Withholding Estimator tool to calculate your tax amount.
Once you’ve figured out your anticipated tax bill, check to see how much you’ve paid in estimated payments throughout the year. You can view this online at any time through the IRS website.
Read more: How to Calculate Your Self-Employment Taxes
What to do if you underpaid your estimated taxes
If you haven’t paid enough in estimated taxes in any quarter this year, you may not be able to avoid penalties entirely. Getting current now won’t negate any interest that you owe for underpayments during previous quarters, but it can reduce the amount you’ll owe.
“You can reduce the penalty by making the full payment before the January 15 due date,” said Mark Steber, chief tax information officer at Jackson Hewitt.
If you underpaid for any quarter in 2023, Ronald suggests making estimated tax payments as soon as possible to get current on your tax bill and reduce interest charges.
You can also increase your tax payments through other sources to help offset underpayment penalties, said Gail Rosen, a tax specialist and CPA in New Jersey. “If you are paid as a W-2 employee, receive retirement payments or social security, you can increase your withholding for the remainder of 2023.” You can increase your withholding amount by adjusting your W-4 through your workplace or SSI office at any time during the year.
What if you overpay your estimated taxes?
If you miscalculate and pay too much in taxes, that money isn’t gone. The IRS will issue you a refund for the overpayment. However, even if you overpay for the year, Steber notes that you could face a penalty if any of your quarterly estimated payments were too low.
Experts don’t recommend overpaying to avoid penalties, since this can tie up funds with the IRS unnecessarily. “Keeping your overpayments to a minimum allows you to utilize those funds for other financial needs or investments,” Ronald said.
Expert tips for reducing your tax burden
Paying taxes isn’t fun, but there are tax credits and deductions self-employed individuals, side hustlers and business owners can use to reduce the amount they pay.
Some of the daily or annual costs of doing business can lower your tax requirement as long as you keep good records.
“Document all of your expenses for your business, including a home office and expenses for using your personal vehicle in your business,” Steber said. “Reducing your net profit reduces both your income taxes and your self-employment taxes, which can lower your overall tax liability.”
“Self-employed individuals may also qualify for a 20% QBI deduction in addition to their business expenses and their standard deduction,” Bronnenkant said. You’ll need to meet specific income and earnings criteria to qualify for the QBI deduction.
For more tax advice, check out CNET’s recommendations for top self-employment tax software and review these tips from a business owner on how to make filing your freelance taxes easier.
Source: CNET
