Taxes on irregular income

by Philip Brewer on 25 March 2008 7 comments
Photo: Philip Brewer

This is really a non-issue, if you work a regular job:  Your employer withholds taxes.  It's also not much of an issue if you're self-employed and your income is reasonably steady through the course of the year:  You estimate your annual tax bill and send in quarterly estimated tax payments.  If your income is unpredictable, though, it is an issue.  Happily, the IRS does not demand that you be able to predict the future.

I'm in this situation myself.  Although I've got a few months experience as a full-time writer, that's not enough for me to produce an accurate estimate of what my income is going to be this year.  That makes it really tough to file my quarterly tax payments (or even to know whether or not I need to).

The rules

The current rules were put in place to deal with people who tried to game the system by holding onto their money until the last minute (thereby keeping for themselves interest that the IRS figures belongs to Uncle Sam).  If your earnings are level though the course of the year (and you don't have money withheld by your employer), then you have to make substantially equal quarterly payments.  If you try to back-end load those payments, you owe interest for the amount that each quarterly payment was short of being its equal share.

Estimating income

It's easy enough to come up with an estimate of the investment income--it'll be about the same as last year's.  (It's also pretty low, as the biggest chunks of investments are in IRAs.)

In a sense, it's easy to estimate the business income as well--I just averaged the last three months for which I have final data and then multiplied by 12 to get an annual value.  The problem is, what if the actual results are wildly different from my estimate?  If you underpay your estimated taxes, you have to pay interest on the underpayment.

Documenting irregular income

The IRS does make it clear that you didn't have to make quarterly tax payments on income until you receive it.  But it also automatically calculates the interest that you owe, if your quarterly payments come up short.

After doing some research, I've found the place where you can document the uneven earning stream:  It's Schedule AI of form 2210.  (That happens to be the same form that you'd file to figure the penalty that you owe for underpayment.)

It's not something to undertake lightly:  Schedule AI looks like a nightmare version of an ordinary tax form.  There is, however, a weird kind of logic behind it.  Basically, there are four columns for the four quarterly tax payment periods.  For each quarter, you put in how much money you made that quarter (and some other stuff about your deductions and exemptions).  You can then calculate how much tax you need to pay for that quarter.  An additional source of confusion comes from the fact that you have to "catch up" to the current quarter if you receive more in later quarters than in earlier, but at least you don't have to pay taxes on money that you haven't gotten, nor do you have to pay interest for being late, as long as you make the payment for the quarter in which you received the money.

The IRS document with all this info is Publication 505 Tax Withholding and Estimated Tax.  Check out the example for Schedule AI of form 2210.

If you expect your income to be relatively stable through the course of the year, you don't need to fiddle around with any of this, and you can just go with Form 1040-ES Estimated Tax for Individuals.

This being tax law, there are (of course) special rules if you make most of your money from farming or fishing.

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Catherine Shaffer's picture

There's no penalty if you underpay for the first time this year. If you are transitioning to freelancing from a regular job, you should have easily paid the required 90% of your liability in withholding from your paychecks. The second year, as long as you pay the amount on your vouchers (your accountant or tax software will create these for you, or you can use a worksheet to make them), you will not owe interest or penalty. As a practical matter, I earmark 20% of my gross for taxes, and that seems to work out well. My husband is a salaried employee and pays through withholdings, so a person with only freelance income should use a higher percentage making sure to cover income tax as well as the full 14% self-employment tax.

Catherine Shaffer

Wise Bread Contributor

Philip Brewer's picture

You're right that it's really a transition-year issue.  Or rather, a "two transition years" issue.

In my case, last year was actually the transition year--the place I used to work closed in August.

There's a safe-harbor position:  If you send in 100% of what you owed last year, then you're safe.  But that doesn't work for me, because what I owed last year is more than 20 times what I expect to owe this year.  Still, it's always possible that I'll end up earning a lot more in the second half of the year than I've been earning so far.  Obviously, that'd be great.  So, it's nice to know that, if I am so lucky, it wouldn't leave me screwed as far as taxes go.  I can file Schedule AI of form 2210, if I have to.

Guest's picture
Miranda

This is a great overview. I started using an accountant for the first time for 2007 taxes. I was pleasantly surprised by the prepared vouchers. Very convenient.

Guest's picture
Margo

How does it work if your freelance income is a 2nd job? At what ratio of freelance:salary income should I start paying attention to quarterly payments? I earn anywhere from $20 to $500 extra in a given month.

Philip Brewer's picture

If you've got a regular job that's withholding taxes, you can usually just adjust the amount being withheld to cover what you're earning. The second page of the W-4 form has instructions for people with a second job.

If your income is highly variable, though, Publication 505 Tax Withholding and Estimated Tax (that I linked to above), has the gory details for figuring out if you need to withhold extra.

It's hard to actually provide a rule of thumb, because the dollar amounts can be so different from one person to the next. As long as you weren't short last year (and you have at least as much withheld this year as you owed last year) you're safe from penalties. But, if your freelancing income starts small and then grows over the course of the year, you could find yourself owing a surprising amount to the government--a surprise that can be unpleasant, even if they don't tack interest on top.

Guest's picture

Great info here! I wonder if anyone has any advice on how to find a good CPA if you're new to an area or don't have any network contacts that use CPAs.

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Angie

Great article.

I just left my part time job and started a small housecleaning business. I am baffled by prepaying taxes, as I have no idea how much I will make.

Thanks
Angie