How To Avoid Those Tax Time “Gotchas”!
For most American citizens who have W-2 income and receive a regular paycheck, tax time is a once-and-done proposition. Taxes are paid through employer withholding, the return is filed, and the check is mailed. But for those who are independent contractors, self-employed or work on straight commission, tax planning is a year-round duty full of potential “gotchas.”
If you do not work for an employer who deducts income taxes from your pay (i.e. you receive an IRS form 1099) or you are self-employed, it’s your responsibility to determine how much to deduct from your income to meet your tax bill AND to pay the estimated taxes throughout the year. Uncle Sam expects this in the form of quarterly estimated taxes. As the name implies, this is an estimate of your tax liability that you pay the IRS quarterly.
Save As You Go
The tricky part of this is nailing down your tax bill. Since you can’t always predict your income three months in advance, it’s smart to save as you go. That way you’ll have the money to pay your quarterlies when they’re due.
To be safe, plan to set aside 30-40% of your income to cover your Social Security and income taxes. That sounds like a lot, but you do not want to come up short on your estimated taxes. If you don’t pay enough, you’ll be subject to penalties even if you’re due a refund at the end of the year.
Create a Separate Account for Taxes
You can basically withhold on yourself by setting up a separate savings account just for taxes. If you’re self-employed, set up a separate checking account for your business activity as well. Deposit all income from your business into the checking account and pay any expenses such as travel, cell phone, business cards, etc. from that account. The remaining balance is profit. Subtract your “withholding” and transfer it to your savings until it’s time to pay your taxes.
How to Avoid Mistakes and Penalties
No one wants to pay penalties on top of taxes, so when it comes to figuring your exact tax bill, you’ll want some help. Your bill will be based on your expected adjusted gross income, taxable income, taxes, deductions and credits for the year. A tax professional can identify all the deductions and credits you’re due while making sure you meet your tax obligations.
How to Lower Your Tax Bill
The next post will discuss how maximize your deductions to ensure that you only pay what you are legally required to.