Your first year self-employed: what you actually owe, and when

Nobody is withholding for you anymore

On a W-2, your employer withheld income tax every payday and quietly paid half your Social Security and Medicare tax. Working for yourself, both of those jobs become yours. Same income, same taxes, different plumbing, and the plumbing is the part that hurts.

You now owe two separate taxes

Income tax

Same brackets as everyone else, applied to your net profit, meaning revenue minus deductible business expenses. Profit is what is taxed, not what hits your bank account.

Self-employment tax

This is Social Security and Medicare for the self-employed, and it is the one nobody expects. The rate is 15.3 percent: 12.4 percent for Social Security on earnings up to an annually adjusted wage base, plus 2.9 percent for Medicare with no cap. An additional 0.9 percent Medicare tax applies above $200,000 of wages and self-employment income for a single filer, or $250,000 filing jointly.

Two pieces of good news. It is calculated on roughly 92.35 percent of your net earnings, not all of it, and you deduct half of the self-employment tax in figuring your adjusted gross income. You may also qualify for the qualified business income deduction, which can reduce taxable income from a qualifying business by up to 20 percent, subject to limits.

You owe self-employment tax once your net earnings from self-employment reach $400 for the year. That threshold is low on purpose.

Quarterly estimated payments

Because nothing is withheld, the tax system expects you to pay as you go. Estimated payments for a calendar-year individual are generally due:

• April 15, for January through March
• June 15, for April and May
• September 15, for June through August
• January 15 of the following year, for September through December

If a date falls on a weekend or a legal holiday, it moves to the next business day. Miss them and you owe an underpayment penalty, which functions like interest on the amount you should have paid when you should have paid it, even if you settle up in full by April.

The safe harbor is your friend

You avoid the underpayment penalty if your payments and withholding for the year total at least:

• 90 percent of the tax shown on this year's return, or
• 100 percent of the tax shown on last year's return, or 110 percent if your prior-year adjusted gross income was over $150,000.

The prior-year safe harbor is the practical one, because you can compute it in January and stop guessing. Note that it protects you from the penalty, not from owing the tax. If this year is much better than last year, you still write a check in April, you just do not pay a penalty for the timing.

One useful trick: if you or a spouse also have W-2 income, withholding is treated as paid evenly across the year no matter when it happened. Bumping up withholding late in the year can cure an earlier shortfall in a way that a late estimated payment cannot.

How much should you set aside?

The common rule of thumb is 25 to 30 percent of net profit, in a separate account you do not touch. That covers self-employment tax plus a moderate federal bracket for many people. If you are in a higher bracket or a state with meaningful income tax, it needs to be more.

The rule of thumb is a placeholder, not a plan. A projection based on your actual numbers takes an hour and replaces the guess. That is exactly what a mid-year check-in is for, and doing it in July instead of the following April is the whole difference.

What you can actually deduct

The standard is expenses that are ordinary and necessary for your trade or business. Common ones people miss in year one:

• Business mileage, at the standard rate, if you keep a contemporaneous log. The log is the requirement, not a suggestion.
• Home office, if a space is used regularly and exclusively for business. There is a simplified per-square-foot method and an actual-expense method.
• Self-employed health insurance, deductible in figuring adjusted gross income within limits, if you are not eligible for an employer plan.
• Retirement contributions to a SEP-IRA, SIMPLE, or solo 401(k). This is the largest legitimate lever most self-employed people have, and the solo 401(k) usually allows the most.
• Software, professional fees, supplies, phone and internet at the business-use percentage, equipment, and continuing education in your existing field.
• Startup costs from before you opened, which are handled under a specific set of rules rather than simply expensed.

What you cannot deduct: personal expenses with a business story attached. The rules on meals, travel, and vehicles are specific, and they are exactly where examinations focus.

Three things to do in your first month

1. Open a separate business bank account. Everything else gets easier. Commingled accounts are the single largest driver of bookkeeping cost and of lost deductions.
2. Start bookkeeping now, not in January. Reconstructing a year from bank statements costs far more than keeping up with it, and it always finds less.
3. Get a projection done. Know your quarterly number before the first due date instead of discovering it fourteen months later.

Do you need an LLC or an S corporation?

Usually not on day one. An LLC is a legal structure, not a tax structure, and by default a single-member LLC is taxed exactly like a sole proprietorship. It buys liability separation, not tax savings.

The S corporation election can save self-employment tax once profit is consistently high enough to justify running payroll, paying reasonable compensation, and filing a separate return. Below that level the added cost and complexity usually exceed the savings. It is a real calculation with a real crossover point, and it is worth running before you incorporate rather than after.