Forty-four million workers—or 28 percent of the workforce—were self-employed during some point of 2019, according to Gallup data.
In the last few years, Millennials especially have taken advantage of side hustles to accelerate their financial goals and boost their overall income. While getting started on apps like Uber, Doordash, and Rover is pretty straightforward, understanding how self-employment affects your taxes can be decidedly more complicated and less transparent.
That’s why many individuals with side hustles may have been surprised to find out they actually owed taxes the first year they reported income outside of their 9 to 5 on their returns. How can this happen? Let’s break it down further.
Defining self-employment and uncomplicating the tax code
Self-employment isn’t just reserved for the owners of your favorite coffee shop or your wedding photographer. The reality is, if you’re part of the gig economy, you’re actually classified as a small business owner. While you can intentionally form a business entity like an LLC, even if you don’t, you are considered a sole proprietor, meaning you have an unincorporated business with one owner and you report business income on your personal tax return.
When you are the type of employee at a company who receives W2 tax forms, taxes are withheld from your paycheck by your employer. As a freelancer, independent contractor, or other self-employed worker, you are responsible for determining and paying your own taxes (at a different rate than W2 employees), including Social Security, Medicare, and income taxes. If you make at least $600 in a year from a certain company, that business will issue you a 1099 form (which is also sent to the IRS). Depending on how much overall income you’re bringing in, you must pay taxes quarterly throughout the year or once when you file your taxes to both state and federal governments.
So if you’ve found yourself in the situation where you filed your taxes and saw a big number that you owe, you’re not alone. While this can be a scary and overwhelming predicament, try to keep calm. None of this is obvious, and you didn’t miss a foolproof ‘Freelancer’s Guide to Taxes’ that was magically sent to your email inbox. This happens more often than you might imagine, and there’s no need to be ashamed. With a little preparation and proactivity, you can fix what you need to fix and prevent it from occurring again.
There are some steps you can take to remedy the situation, but first things first—treat yourself with kindness. We are often our own harshest critics. If one of your friends was telling you about this blunder during brunch, how would you react? Most likely, your response would be characterized by support, sympathy, and encouragement. Lean into that and show yourself the same compassion.
Taking ownership and resolving tax mishaps
If you unexpectedly owe self-employment taxes, here are a few practical steps you can take:
01. Set up a payment plan with the IRS
If you can’t pay your full amount now (which helps you avoid penalties and/or interest), you can apply for an individual payment plan with the IRS as a sole proprietor. You can choose from a short-term plan (you owe less than $100,000) where you pay in 120 days or less, or a long-term plan (you owe less than $50,000) where you pay monthly. Keep in mind that there are set-up fees and you will accrue penalties and interest until the balance is paid in full. Because of this, you’ll likely want to prioritize paying off this debt over any other debt you may have. The good news is that you can choose automated direct deposits so you don’t miss a payment to the IRS.
02. Reserve a portion of your business income in a separate account
As a sole proprietor, you will need to either a) pay all of your self-employment taxes at the end of the year or b) pay quarterly taxes. How will you know which one you fall into? That depends on your tax liability. If you expect to owe taxes of at least $1,000 when you file your return, you need to make quarterly tax payments that are due on the 15th of the month in April, June, September, and January. (Find out more about calculating estimated tax payments on this TurboTax page or The Balance). Regardless of when you pay, it’s a good idea to move your estimated tax payments into a separate bank account throughout the year. This will help you keep these funds earmarked for a specific purpose, and eliminate any confusion about how much of your freelance income is actually yours, versus how much belongs to the IRS.
03. Rethink your freelance rates.
If you have any control over your rates (you babysit, do graphic design, teach piano, etc), you might be dismayed when you realize that your actual take-home after self-employment taxes is 15.3 percent less than your base rate. So, what can you do? Adjust your rates accordingly by advocating for yourself. Pitch your clients a 15 percent higher rate to offset the expense, while demonstrating your value and results. Most people aren’t expecting your services to cost the same forever, especially if you haven’t raised your rate in a year or longer. Or, upsell your clients with new or expanded services or additional work.
04. Implement a system.
So you’ve remedied your past errors and are ready to (knock on wood) never make that mistake again. But as Benjamin Franklin noted, failing to plan is planning to fail. Now is the time to be proactive by developing a specific system that works for your unique situation. Start with keeping accurate records. The headache of searching for past numbers can be lessened by streamlining your recordkeeping. Consider bookkeeping tools like QuickBooks Self-Employed, Wave, AND CO, or others from this list. Then, set calendar reminders for tax payments—put the dates in your planner, a bulletin board by your computer, and your digital calendar of choice.
Moving forward with poise
Becoming a freelancer or adopting a side hustle doesn’t mean you have to become well-versed in tax law. But it may necessitate a few hours of research and dedication to a process that ensures you’re taking care of things properly for your business, no matter how small it may be. (Check out a few more tax tips to get started.)
If this all sounds daunting and overwhelming, you may benefit from consulting with an accountant (especially if you are a new full-time freelancer or desire to become one). They can make this whole process much simpler for you by handling your calculations and making expert recommendations for how to best tackle your self-employment taxes. Most importantly, the cost of accounting services could be well worth it for your peace of mind and sense of confidence.