How Much Should I Save for Taxes as an Independent Contractor?
Essential guide for independent contractors to proactively plan and save the correct amount for their tax obligations.
Essential guide for independent contractors to proactively plan and save the correct amount for their tax obligations.
As an independent contractor, managing your taxes differs from traditional employment. Unlike employees who have taxes withheld from each paycheck, independent contractors are responsible for calculating and paying their own taxes. This requires understanding your tax obligations to avoid penalties. Setting aside funds throughout the year is a necessary step in fulfilling these responsibilities and maintaining financial stability.
Independent contractors face two primary types of federal taxes: self-employment tax and federal income tax. State income tax obligations may also apply depending on where you reside and operate your business.
Self-employment (SE) tax covers your contributions to Social Security and Medicare. For traditional employees, these taxes are split between the employee and the employer. As an independent contractor, you are considered both the employee and the employer, totaling 15.3% of your net earnings from self-employment. This rate includes 12.4% for Social Security, up to an annual earnings limit, and 2.9% for Medicare, which applies to all net earnings.
Beyond self-employment tax, you are also responsible for federal income tax on your net earnings. This is the same income tax that traditional employees pay, but as an independent contractor, no employer withholds it from your payments. The amount of federal income tax you owe depends on your overall taxable income and applicable tax brackets.
Many states also impose an income tax, and independent contractors are subject to these. The rules and rates for state income tax vary widely by state. It is important to determine if your state requires estimated tax payments in addition to federal requirements.
Accurately estimating your taxable income is important to determining how much you should save for taxes. This involves tracking your gross income and identifying all eligible business expenses and other deductions. Your taxable income is your gross income minus these deductions.
Gross income for an independent contractor includes all payments received from clients. Track every source of income, regardless of whether you receive a Form 1099-NEC. Even income below the reporting threshold from a single client must be included in your gross income.
An advantage for independent contractors is the ability to deduct qualifying business expenses, which reduce your gross income to arrive at your net earnings from self-employment. Common deductible expenses include:
A portion of home office costs if you use a space exclusively and regularly for business, such as rent, utilities, and insurance.
Costs for supplies, equipment, and software directly related to your work.
Professional development, business travel expenses including transportation and lodging, and 50% of business meal costs.
Health insurance premiums if you are not eligible for an employer-sponsored plan.
Contributions to self-employed retirement plans, such as a SEP IRA or Solo 401(k), which can also lower your taxable income.
Other deductions available to individuals can further reduce your taxable income. These include the standard deduction or itemized deductions, whichever provides a greater tax benefit. Contributions to a Health Savings Account (HSA) are also deductible. These deductions are applied after your net earnings from self-employment have been calculated, lowering the income subject to federal income tax.
Once you have estimated your taxable income, the next step involves calculating your estimated tax liability. This calculation combines your self-employment tax and your federal income tax, taking into account available deductions and credits.
The self-employment tax is calculated on 92.35% of your net earnings from self-employment, provided these earnings are $400 or more. The combined Social Security and Medicare tax rate is 15.3%. For example, if your net earnings are $50,000, you would first multiply that by 0.9235 to get $46,175. Then, apply the 15.3% rate to this amount to determine your self-employment tax.
A portion of your self-employment tax is deductible when computing your adjusted gross income (AGI). You can deduct one-half of your calculated self-employment tax. This deduction helps offset the burden of paying both the employer and employee portions of Social Security and Medicare taxes.
Federal income tax is then calculated on your taxable income after all deductions, including the self-employment tax deduction. The federal tax system uses progressive tax brackets, meaning different portions of your income are taxed at increasing rates. Various tax credits, such as the child tax credit or education credits, can directly reduce your calculated tax liability dollar for dollar, lowering the amount you owe. State income tax is calculated based on your state’s specific rates and rules.
After calculating your estimated tax liability, the next step is to make timely payments throughout the year. The U.S. tax system operates on a pay-as-you-go basis, meaning taxes should be paid as income is earned. For independent contractors, this involves making quarterly estimated tax payments.
Estimated tax payments are due on specific dates throughout the year: April 15 for income earned January 1 to March 31, June 15 for income earned April 1 to May 31, September 15 for income earned June 1 to August 31, and January 15 of the following year for income earned September 1 to December 31. If any of these due dates fall on a weekend or holiday, the deadline shifts to the next business day.
There are several methods for making these payments. You can pay online directly through IRS Direct Pay, which allows you to schedule payments in advance. Another option is the Electronic Federal Tax Payment System (EFTPS), a free service that also allows scheduling payments up to a year in advance. Payments can also be mailed with Form 1040-ES payment vouchers or made through tax software.
It is important to pay sufficient estimated taxes throughout the year to avoid underpayment penalties. Penalties may apply if you owe $1,000 or more in tax and do not pay at least 90% of your current year’s tax liability or 100% of your prior year’s tax liability, whichever is smaller. For higher-income taxpayers, the prior year’s tax threshold increases to 110%.