I never expected to hear tax advice at a comedy open mic. But right after I got up and bombed, the next comic started talking about how freelancing the previous year screwed over his finances. “I knew that I was supposed to be setting aside money for taxes,” he said, “But I figured it would come to, what, maybe fifty dollars?
“Guys,” he said after a pregnant pause. “It was more than fifty dollars.”
In the way of open mics, most of the other people there were barely paying attention — getting ready for their own sets, or trying to figure out where they had already gone wrong. But I’ll bet that most of them were like me and the guy on stage, doing freelance or “sharing economy” gigs to make ends meet while pursuing a creative career. And they should’ve been hanging on his every word.
People with ordinary jobs have their taxes withheld from their paychecks by their employers. Not so for the growing numbers who earn their income freelancing, or via apps like Uber or TaskRabbit. Taxes aren’t withheld from any of the income you get from those sources, and just as most employees are only vaguely aware of how much tax is being taken out of their paychecks, most freelancers — at least at first — don’t realize that they’re supposed to be keeping track of the tax they owe on self-employment income and paying it to the government four times a year.
“Many of my clients are real estate agents, actors, writers, or other small business owners,” says tax preparer Brenan Cavish, an Enrolled Agent with Norwalk Business Service in Southern California. “It doesn’t matter what the business, this issue usually comes as a surprise to them. I have tissues in my office for the bad cases.”
If you’re self-employed, how can you avoid ending up sobbing in front of a tax professional? Some hard-earned experience from your fellow freelancers will hopefully help guide you in the right direction.
Set aside money as you make it.
This knowledge gap was a common theme among freelancers I spoke to. “I really didn’t realize at first that my checks weren’t being dinged for taxes,” says one dot-com era freelance Web designer, “and even after I did, I had no idea that I was responsible for quarterly tax payments. I just figured that the spring would roll around and I’d file my taxes and pay for it then.”
Leonard Pierce, a self-employed writer, editor, and proofer, says that, in his first year of earning a lot freelancing, “My girlfriend at the time said, ‘You know you’re going to have to pay taxes on that, right?’ but I didn’t understand the mechanism; I think I had a half-formed idea that it worked kind of like regular paychecks, and I certainly didn’t realize they all came due at the same time.”
By not paying quarterly as they earned their freelance cash, Leonard and the web designer were set up for trouble when their income dropped precipitously the following year, just as they discovered their debt to the IRS; both ended up in situations where they had their wages garnished.
“Pay your quarterly estimated taxes,” Cavish urges, “and try to pay all the tax you’re going to owe. The penalties for late payment add up really fast. It’s important to pay any balance due by April 15 or they start assessing a 0.5% a month penalty even if you file your return and apply for an extension. That penalty is 5% a month if you forget to file.”
Don’t underestimate the expense and end up surprised.
Even people who know they have to set aside money for taxes often have only a hazy and overly optimistic idea of what they’re really going to owe. One landscape designer says that when she started freelancing, “I knew that I wasn’t paying SSI, Medicare, etc., so I set aside maybe … ten? … percent to cover these at the end of the year,” a figure guided in part by the amount withheld from paychecks she had earned in food service. “Tax time rolls around and it turns out I somehow owe about $7,000! I had set aside about $2,500.”
Determining how much you should set aside is a tricky business, but using your old pay-stubs from steady jobs as a guide is often misleading. Your boss is matching your Social Security and Medicare taxes behind the scenes; if you’re your own boss, you pay self-employment tax as the equivalent, and that adds up to 15.3% of your self-employment income. “This extra tax liability almost always surprises people who are self-employed during their first year in business,” says Cavish. “Combined with state and Federal income tax liabilities, it’s very easy to get to a tax due of 40 to 50% of the net earnings from your business.” You need to keep this in mind when setting your rates: in essence, you need to charge about twice what you need to live on.
Keep meticulous records.
Your relationship with freelance clients is much looser than a relationship with an employer, and while clients should send you documentation of your earnings, the chances for mistakes, especially with clients you haven’t dealt with in months, are much greater.
In 2013, Mark Popham was an assistant editor, but “did a bunch of freelance work as a graphic designer on the side; I never got a 1099 but I guess they sent a copy to the federal government. By the time I was doing my taxes in March of 2014, I had completely forgotten that I had worked at this place; I assumed that I had gotten less than $400. It was a much larger number, which I found out this year when I got a huge bill from the IRS, the wheels of the IRS grinding slowly but incredibly finely.”
The landscape designer I spoke to learned to obsessively track “every mile, square foot, and expense,” but, reflecting on her training, she says: “I learned 500 ways to draw trees, but zero ways to run a business in a field that is about 90% contractors and sole proprietors.”
If hustling for gigs and freelance work is the future of the U.S. economy, then we need better practical education before we throw young people out into the working world, and better guidance once they’re there. Some sharing economy apps do try to offer information on quarterly taxes—AirBnB has a page with tax tips for hosts, for instance—but for others, your best bet is to connect with others in your industry (possibly your competition). Or maybe you’ll hear some great advice at a comedy night.