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Withholding and Self-Employment

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A reader recently asked in the forum:

I've got a lot of contract work queued up for 2004, and I only managed to escape extra tax this year because I was laid off and out of work for a couple of months and took a pay cut when I got my next job.... How do I calculate how much withholding I should add?

My response:

Certainly, you can increase your withholding at work to cover your additional taxes from your self-employment. However, the calculations for figuring your additional withholding is going to be different than calculating your regular withholding.

That's because as a self-employed person, you are responsible for both the employer's and the employee's portion of FICA--the Social Security and Medicare taxes. On your paycheck, you pay 7.65% in FICA taxes, and your employer pays the other 7.65%. As a self-employed person, you pay the full 15.3%. On the Form 1040, this is called the Self-Employment Tax.

Here's how I would calculate your withholding for next year.

First, calculate how many allowances to claim based on your situation. Claim one allowance for yourself, plus one for each dependent you have. This will establish a base for your withholding.

Next, project how much you expect to earn from your side jobs as an indepedent contractor. Also, project how much you plan to spend to cover various expenses for your side jobs. Calculate the difference between your earnings and expenses, to arrive at your estimated profit for the year. Now, multiply your profit by 15.3%. This is how much you should set aside for your Self-Employment Tax. Take the same profit figure, and multiply it by your marginal tax bracket. (If you are in the 25% tax bracket, multiply your profit by 0.25.) This is how much you should set aside for your additional income tax.

Now, add the two tax numbers, and divide by the number of paychecks for the year. This is how much extra withholding you should request to be taken out of your paycheck. Put this on line 6 of your Form W-4.

Finally, you asked about your 401k. You can defer taxes on any income you set aside in your 401k plan. You should think about maxing out your 401k contributions if you want to shelter as much money as possible from taxes.

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