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Author: xraymd Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 308438  
Subject: Re: It does hurt sometimes Date: 9/1/2003 11:05 AM
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So far I've been paying a little over $2K/yr in income tax the past couple years, on adjusted gross income of around $15-$18K. Nobody has come after me yet re: quarterly estimated taxes, and the only penalties I've had are on account of having to file an extension and pay late.

I am blessed not to have to pay state income tax in Florida.

50%??? Are you sure??? My accountant told me to withhold about 30% to stay on the safe side, maybe because he knew I would not be getting into a really high tax bracket at that time (a couple years ago when I started getting mural work for Martha).


Greetings, Mare, I did some further checking and it seems like 50% self-withholding may be overgenerous BUT 30% may be too low. Here are the facts for 2003 (from the link, but I will include the numbers here):

http://www.irs.gov/newsroom/article/0,,id=108862,00.html

For annual incomes up to $7000, the tax bracket is 10%. For additional dollars earned, from $7001 up to $28,400, the tax on those dollars is 15% (like a tiered credit card interest rate). You would have to earn beyond $28,401 up to $68,800 for those additional dollars to be subject to 25%. These brackets are for a single person.

So in actuality, the tax rate is graduated and you start owing the higher brackets on only those dollars earned beyond the lower bracket. Using your example of say, $18K per year (assuming this is fully self-employment income), the federal tax owed for 2003 would sum to:

10% on $7000 = $700 PLUS
15% on $18,000 - $7000 ($11,000) = $1650

$700 + $1650 = $2350. Note that this is just for the federal tax and does not include FICA (Social Security) or FHI (Medicare).

[If you decided to overwithhold and to use the figure of 15% withholding against every dollar of self-employment income earned just for ease of calculation and planning, your federal tax estimate would be 15% of $18K, = $2700]

Now the amounts for FICA and FHI have to be figured in. Money earned through payroll has one-half the FICA and one-half the FHI paid for by your employer. But money you earn through self-employment must have the full amount held back in reserve (I believe Schedule SE recredits you for some of this tax). If you look at your paystub, you will find that 7.65% of your gross is withheld for FICA and 1.45% is withheld for FHI. Each of these percentages are half of what you will owe against your self-employment income.

That means you will have to do your own withholding for FICA at a rate of 15.3% (= 2 x 7.65) and for FHI at a rate of 2.9% (= 2 x 1.45). On an annual income of $18K, this amounts to:

15.3% of $18K = $2754
2.9% of $18K = $522

Since there is no income tax in Florida, you can get your estimate of taxes owed right here by summing what you owe for federal, FICA and FHI. If you use the tiered method of figuring tax, add together $2350 + 2754 + 522 = $5626. This amounts to a little over 31% of the annual income and suggest that it would be necessary to set aside at least this percentage of each self-employment check received.

But wait! There's more! (Where taxes are concerned, there is ALWAYS more, but in this case, it's a good thing.) I haven't taken the standard deduction into consideration. This allows you to subtract off a portion of your income for the purpose of calculating the federal tax owed (FICA and FHI taxes are based on the full adjusted gross amount, in this case $18K). For 2003, the standard deduction for a single person is $4750, which means that federal tax is figured on only $13,250 of your income. This reduces the federal tax owed to:
10% on $7000 = $700 PLUS
15% on $13,250 - $7000 ($6250) = $937.50
Total federal tax estimate, taking the standard deduction into account:
$700 + $937.50 = $1637.50
TOTAL SELF-EMPLOYMENT TAX including federal, FICA, FHI:
$1637.50 + $2754 + $522 = $4913.50.

Okay, that's better than $5626 and is closer to 28% self-withholding once the standard deduction is taken into account so I will concede to your accountant that 30% of every self-employment dollar should be safe to set aside for tax day!

Another hint, Mare, to your advantage: Don't forget to add up all the interest you have been charged on your student loan for the year (found in a form 1098 which your lender should supply you). This interest, dollar for dollar up to $2500, FURTHER REDUCES your gross income because you can take it as an adjustment (a subtraction) to your income every year in which you owe student loan interest and your earned income is below a certain level. That adds up to more tax savings on taxes you WON'T owe because of this adjustment.

Regarding estimated quarterly taxes: the only time you would be expected to make quarterly payments on this tax would be if, after all money already paid to the IRS on your behalf through payroll withholding, you still owe a total of more than $1000 out of pocket. Then the IRS wants its portion 4 times throughout the year and gets mad if you send it in all at once at the end of the tax period.

I am aware this all seems pretty daunting. But I am also certain that it is digestible and understandable, bit by bit. Taxes are pretty much arithmetic (no higher math involved!) and if you start with the simplest of tax forms (the 1040EZ), it becomes clearer to understand that taxes are structured the same way every year:
1) What I earned (payroll wages)
2) What I must add to income (self-employment wages)
3) What I can subtract from income (student loan interest, 401(k))
<== The sum of these is your adjusted gross.
4) Exemptions and deductions from adjusted gross (standard or itemized)
5) Final figure on which tax is based

Points 3) and 4) are the fun ones for they reduce your tax. Learning what goes into them is worth your time - given that taxes are a necessary evil. The more you don't owe the IRS, the more what you earn stays in your own pocket. Practice at taxes will make you proficient at spotting situations where you can make a tax-advantaged financial move. Knowledge is power! You can definitely afford self-employment but it helps to know how taxes work so that you can set your fees as necessary to account for the inevitable tax against them and net enough to live on and to build for the future.

I have huge admiration for your artistic gifts, and for your derring-do. I also have tremedous faith that you are on the verge of learning what you need to learn to set up your future to take care of itself. Go, Mare! And good luck with taxes in 2003.

xraymd
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