A couple of tax seasons ago, I got a call from my dad asking for some help on my sister’s tax return. He was preparing it on do-it-yourself tax software. After he had entered the few items she had, he was perplexed at the summary in the top right corner. It showed her tax bill was about half of her taxable income. When he explained everything over the phone, it didn’t make much sense. I wasn’t sure what was going on. A 50% tax rate would be pretty steep. So shortly thereafter, I stopped by his house to see what was going on. After taking in the situation, the numbers in the summary section were correct. The problem? The self-employment tax.
Here are some details to help make sense of the situation. At the time, my sister was living at home attending college. She had a couple of part-time jobs; one as a receptionist and the other as a dance teacher. As a receptionist, she was treated as an employee and as such, the company withheld from her paycheck Social Security, Medicare, federal, and state income tax from her wages. However, as a dance teacher, she was treated as an independent contractor. As such, she was responsible for those items.
Her income was fairly low overall, and generally speaking, if you have a low income, most of your income is wiped out by the standard deduction. This usually results in very little or no tax owed. However, what caught my sister up was self-employment tax. Self-employment tax is Social Security and Medicare for self-employed individuals. This is calculated based off of net business income (business income minus any business expenses). So that means the standard deduction is not factored in at all.
My sister was surprised to know she owed so much tax. I’m sure she didn’t think she would owe anything. In fact, I’d bet she was expecting a refund. Not a very fun surprise. The lesson to learn from this is to be proactive with your taxes. Avoid the surprise and any potential penalties. If you are required to make estimated payments. Some instances where you may want to make estimated tax payments: if you are self-employed, have significant income from investments or in general, any time your withholdings are less than your expected tax liability. The kicker on top, if your withholdings and/or estimated payments are under 90% of the tax owed that year or 100% of last year’s tax (110% if your income is over $150,000), you will be subject to the underpayment penalty.
Making estimated tax payments won’t help you to avoid the tax, but it will help you to avoid the penalty. If you are not sure if you need to make estimated tax payments, talk to your tax advisor. It’s what we are here for.