7 Ways to Avoid Self-Employed Tax Penalties

People who are self-employed are required to send in quarterly estimated tax payments. But if your income varies from month to month or year to year, it's tough to determine the amount of taxes to pay. You don't want to send in so much that your daily expenses suffer or so little that you get slapped with a shocking tax bill at tax return time, not to mention underpayment penalties.

KEY TAKEAWAYS

• Open separate checking and credit card accounts for your business. This will provide you with an easy reference for your business expenses and income.
• File your quarterly payments and, if anything, overpay a little. You'll get it back.
• The first year, get advice from a self-employed friend, an accountant, or the IRS helpline.

Important: The federal income tax filing due date for individuals has been extended from April 15, 2021, to May 17, 2021. Payment of taxes owed can be delayed to the same date without penalty. Your state tax deadline may not be delayed.3

Follow one or more of the following tips for calculating your quarterly estimated tax payments to minimize your chances of incurring penalties or breaking your budget.

1. Base Your Payments on Last Year's Earnings

You can avoid paying a penalty by paying at least the same amount in taxes as you did the previous year if you were self-employed then as well. You can find the total taxes you paid on last year's tax return. Just divide last year's taxes into four equal payments and send each of them in by the IRS's quarterly due dates: April 15, June 15, Sept. 15, and Jan. 15.4

Important: On Feb. 22, 2021, the Internal Revenue Service (IRS) announced that victims of the 2021 winter storms in Texas will have until June 15, 2021, to file various individual and business tax returns and make tax payments. The June 15 deadline also applies to quarterly estimated income tax payments due on April 15.5

If your taxes turn out to be higher this year than last, you will still be liable for what you owe but you won't have to pay an underpayment penalty as well. Let's say, for example, you paid $4,000 in taxes last year. You send in four equal payments of $1,000 this year. You calculate your taxes at the end of this year to be $5,500. You can send the IRS a check at tax time for the $1,500 difference without paying a penalty.6

You should note that if you had no tax liability in the prior year, you won't incur a penalty for not making any payments before tax return time. You can choose how much to send in throughout the year, but be aware that you could have a large tax bill at the end of the year if you don't send in enough.

2. Get Advice the First Year

During the first year of self-employment, talk to a friend who's self-employed or hire an accountant to handle your tax calculations for you. Either way, you can figure out how much to pay, determine what expenses you can deduct, and get comfortable with the process.

3. Use Separate Accounts for Business Expenses

It will simplify your life and make it easier to estimate your quarterly taxes if you open a separate bank account and a credit card account reserved for business expenses only.

These provide records of your business expenses for easy reference come tax time. It's much simpler than wading through a pile of paper receipts when you're doing your taxes, and it's much easier to check back through if a question about expenses comes up.

4. Keep a Running Tally of Your Income

You could get sticker shock next April if you don't keep a running tally of your income and pay your estimated tax accordingly. Calculate your income at the end of each quarter and use this as a basis for whether you should increase or lower your quarterly payments.

If you use that dedicated checking account for your business income deposits, a running tally will take a couple of minutes to check in your online bank records.

5. Use the IRS 1040-ES Worksheet

If your income varies widely from year to year, the best way to estimate your quarterly payments is to use the 1040-ES worksheet from the IRS. The worksheet guides you through calculating your expected tax liability and takes into account certain common deductions you may qualify to claim.

Important: The penalty rate for underpayment is the federal short-term funds rate plus 3%.7

You can fill out the worksheet every quarter, or at least every quarter that represents an unusual change in your income. If your business experiences a significant amount of variation from quarter to quarter, you'll need to adjust your estimated tax payment to avoid a big surprise next April.

6. Always Overestimate, at Least a Little

Tax penalties can be pricey, depending on how much you underestimated your taxes due.

Interest is charged on the amount you underpay from the day your quarterly payment is due until the day it's paid. The underpayment penalty rate is the federal short-term rate plus 3% and is announced quarterly.7 So, if you underpay for the first quarter of a tax year, you could owe a different penalty amount than if you underpay for the third quarter.

If you're unsure of the exact amount to pay each quarter, slightly overestimate your taxes. You won't lose any money in the long-term. You'll just get it back as a tax refund.

7. Put the IRS Tax Help Line on Speed Dial

The IRS's free helpline is your best source for answering any question you may have. The number for individual taxpayers is 800-829-1040.8

Unless you hire someone to do your taxes for you, you are your own accounting department. Unless you actually are an accountant, you may very well have some questions, at least during the first year of self-employment.

The Bottom Line

If you are self-employed, you need to be very careful when calculating and paying your estimated taxes in order not to incur underpayment penalties. If you follow the tips above for calculating your quarterly estimated tax payments, you can minimize your chances of running up penalties or breaking your budget. Always consult with a tax advisor if you have questions relating to your specific tax situation.

Article Sources:

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1. Internal Revenue Service. "Self-Employment Tax (Social Security and Medicare Taxes)." Accessed March 18, 2021.
2. Internal Revenue Service. "Estimated Taxes." Accessed March 18, 2021.
3. IRS. "Tax day for individuals extended to May 17; Treasury, IRS extend filing and payment deadline." Accessed March 18, 2021.
4. Internal Revenue Service. "When are quarterly estimated tax payments due?" Accessed March 18, 2021.
5. IRS. "Victims of Texas winter storms get deadline extensions and other tax relief." Accessed March 18, 2021.
6. Internal Revenue Service. "Topic No. 306 Penalty for Underpayment of Estimated Tax." Accessed March 18, 2021.
7. Internal Revenue Service. "Interest Rates Remain the Same for the First Quarter of 2021." Accessed March 18, 2021.
8. Internal Revenue Service. "Let Us Help You." Accessed March 18, 2021.