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Ask Farnoosh: Paying Uncle Sam When You’re Self-Employed

Charlotte Shaff asks: What is the best way for a self-employed person to save money for taxes each month?
Dear Charlotte,
Unlike the average 9-to-5 office worker, self-employed folks are responsible for estimating their own taxes and paying them quarterly. That can be hard to get used to and manage, especially if you just came from working for a company that issued tax-adjusted paychecks. You could spend and save freely then without the pressure — and pain — to save some for Uncle Sam.
I’m in the same boat. When I started freelancing five years ago I got some great advice from a fellow independent worker, which is what I’ve dubbed the “40% Rule.” Before accounting for deductions like business-related tools, gas, travel and office space (as I assume many freelancers will have), just assume that you will owe 40% from each paycheck to the IRS. Of course, this is a gross overestimate for many freelancers; 39.6% is the highest marginal tax rate in the U.S. and hits those earning $400,000 or more (as a single filer). Most self-employed people’s earnings fall short of that figure so will end up paying less than 40%.
The 40% Rule ensures you won’t fall short when it’s time to pay Uncle Sam. It also insists we automatically set aside 40% of each paycheck for this purpose.
Every quarter, the IRS requires we submit and estimate our tax return for that three-month period. This is when your cushy tax savings account comes in handy. To figure out how much you owe, “take your income for the quarter and subtract the expenses you expect to take on your tax return and other credits to arrive at taxable income,” says Ebong Eka, a certified public accountant. “You then settle up with the IRS when you file income tax returns in the event you've overpaid or underpaid your taxes due.”
If you’re totally clueless, it may be helpful to refer to your previous year’s income, deductions and credits as a starting point. You can also reference this IRS worksheet to calculate your estimated tax.
A quarterly schedule to pay taxes, I find, is helpful because it forces you to stay on top of your financial records throughout the year. Of course, that takes being extra organized. Some advice: “From the beginning of the year, save all receipts that are even partially relevant to your income or work in one secure place,” says Joe Weatherby, a professional tax preparer who specializes in self employed taxes. “Also, keep your calendar up to date when working, trying to find work or doing any activity that is relevant to your career.”
Derek Jackson emails: I am buying a new car with dealer financing. I have good credit. My fiancé has a limited credit history, which is otherwise holding back her flawless credit score. Does it make sense to have her cosign my car loan to add to her credit history? We will be getting her a new car within the next year and the loan in her name. Then in the next five years we will probably move to a bigger house. Our current house is in my name only.
While cosigning this car loan with your fiancé has the potential to help boost her credit score (assuming it gets paid on time), there are easier and safer ways to get her on the right track than attaching her to a large installment loan. The big danger of cosigning is that it could have a negative impact on her debt-to-income ratio, according to credit expert John Ulzheimer. “It’s not a credit measurement, but a capacity measurement,” he says. “It can cause her to not qualify for a car loan when it’s time.”
A safer route for her would be to open up her own credit card and use it regularly and responsibly for the next year. If she can’t qualify for one yet due to a lack of history, she can certainly qualify for a secured card from a local bank or credit union. A secured card is similar to a credit card but rather than provide you with a hefty line of credit, the bank issues you a small line of credit equal to an amount that you deposited, usually starting at around a few hundred dollars. Activity on the card is reported to the three major credit-reporting agencies, helping users establish credit just as a traditional credit card would. You can compare secured card offers at Bankrate.com. After paying off the balance each month for about a year, she may then be eligible for a real credit card. You could also add her as an authorized user to one of your credit card accounts; this allows the account’s history to be reported on her credit report, which will further build her credit. Just keep in mind that as an authorized user, she will be issued her own card and can make charges on the account, but will not be on the hook for payments.
Got a question for Farnoosh? You can reach her on Twitter @Farnoosh or email her at farnooshfinfit@yahoo.com.