The fourth and final estimated tax payment for the year 2011 is due on Tuesday, January 17th. (See: Publication 505.) For independent contractors, this is a perfect opportunity for you to draft out your 2011 tax return to get an idea of how much federal and state tax is due to be paid (your total tax liability), review how much as been paid in so far through previous estimated tax payments, and determine how much extra is due for 2011.
For many independent contractors, including myself, we've been paying estimates based on our 2010 tax liability, divided into four equal installments. That payment schedule works good as an estimating tool, but our actual tax liability for 2011 might be higher or lower than those estimates. The important thing is to pay attention to how much is required to be paid, when those payments are due, and developing a "tax budget" or a schedule of tax payments throughout the year 2012.
Start by tallying up income and expenses related to your self-employed business.
Then, draft out your 2011 tax return. You can do this using online tax software. You don't need to go through every single interview screen on your software. But do go through the sections related to your business income and expenses, and your estimated tax payments.
Find your total tax liability for federal and state taxes, and write those down on a piece of paper. Also write down your gross business-related income, your net business income, estimated tax payments, and the amount of taxes still to be paid. Off to the side somewhere write down your total tax liability (federal and state) for 2011. From here we're going to do some analysis and budgeting. (Your total federal tax liability is found on Line 61 of Form 1040, if your software allows you to preview your 1040.)
Your piece of paper might look something like this:
- Gross business income (before expenses):
- Net business income (after expenses):
- Total federal tax liability:
- Estimates paid in so far:
- 1st estimated payment:
- 2nd estimated payment:
- 3rd estimated payment:
- 4th estimated payment:
- Total estimated payments:
- Balance to be paid (total tax minus payments):
Repeat the tax liability and payment lines for your state taxes.
Now, you're ready to do some analysis and budgeting. We can slice and dice these numbers in several ways, but I'm going to first start with payment deadlines:
- The fourth estimated payment is due by January 17th, 2012. The minimum amount to be paid in is one-fourth of your 2010 tax liability.
- Any remaining tax for 2011 is due by April 17, 2012.
- Your first estimated payment for 2012 is also due on April 17, 2012.
- Your second estimated payment for 2012 is due on June 15, 2012.
From here we can add amounts for federal and state taxes to each of these deadlines.
Let's start by analyzing payments for the year 2011. You can split this up between your 4th estimated payment (due January 17th) and your extension payment (due April 17th). Consider having your 4th estimate be at least one-fourth of your 2010 tax liability, as this will help you avoid the "penalty" (really an interest charge) for underpaying your estimates. Right now, this underpayment penalty is 3% (which is stated as an annual rate). At the very least, your goal should be to have your 2011 taxes paid-in by April 17th so as to avoid the late payment penalty, which runs at half a percent per month.
Next, analyze payments for the year 2012. Your estimates for 2012 will be one-fourth of your 2011 total tax, spread over the four estimated payment due dates. The first payment is due April 17th (the same day your 2011 taxes are due), and the second payment is due just two months later on June 15th.
You can use a spreadsheet or a sheet of scratch paper to sketch out these payment amounts and deadlines. From there you can analyze how to go amount making these payments. Seeing the amounts and due dates organized like this will give you a good overview of your situation.
Now, let's do one more piece of analysis. Find your effective tax rates, which is the ratio of your total tax liability to your net business income. You can calculate separate ratios for your federal, state, and combined tax burdens. This ratio reveals, in a quick way, how much of your net business income goes to taxes.
You can also calculate a similar ratio based on your gross business income. I use this ratio (based on gross income) as a budgeting tool. What this ratio says to me, as a tax professional, is that if I set aside at least this percentage out of gross income, then that will likely be an amount sufficient to cover tax payments. While this ratio method of budgeting is not exact, it is a helpful place to start.
Some additional timing tips for the self-employed.
You don't need to file your return just now. You can wait and file in April, or request an extension and file in October. The more important task is figuring out how much to pay and when, and developing a payment schedule that's manageable.
You can use your tax summary as a benchmark for fine-tuning your tax return. Once you have your basic situation, you can compare what your taxes would look like if you funded an IRA or SEP-IRA, for example. You can also use your summary to compare a tax return prepared professionally versus one you prepared yourself.