What Is Tax Liability? Know What You Owe Before Tax Day Hits
April showers bring May flowers, but April 15 brings the IRS. Whether you’re an independent contractor, freelancer, or small business owner, Tax Day is a big deal that can require as much preparation as a Thanksgiving feast. But even before tax season rolls around, you need to know the answers to two questions: What is tax liability? And what is your estimated tax liability?
Being your own boss comes with plenty of perks, but filing your taxes only gets more complicated. There are new terms to remember, new forms to fill out, and an endless pile of web sources to sort through.
To give you a starting point as you’re getting to know your self-employment taxes, we’re diving into everything you need to know about your tax liability.
What Is Tax Liability?
Tax liability is the total amount of tax debt that you’re responsible for paying to the Internal Revenue Service (IRS), the United States taxing authority. This includes taxes for the current year, in addition to leftover taxes from the previous year if you opted into a payment plan.
Self-employed individuals add to their tax liability in a handful of different ways. These factors include:
- Your income tax: As you earn money in your career, you gain income tax liability. This is the traditional tax that every employed person must pay. Your tax rate will always be based on the amount of money you make. State and federal taxes are both included in your tax liability.
- Your self-employment tax: This is 15.3% of your income, which represents your Social Security and Medicare contributions. This is already taken out of your paycheck when you’re employed, and it’s half the cost because it’s partially covered by your employer.
However, the taxes you accrue based on the factors above don’t represent your final tax liability. Your total tax liability is the number that’s left after you subtract your non-refundable tax credits and tax deductions.
Non-refundable tax credits are a type of deduction that can reduce your final tax liability to as low as zero. For example, if you owe $7,000 in taxes and had $8,000 in non-refundable credits, you won’t have to pay anything extra, but you won’t receive the extra $1,000 in the mail as a cash refund. Non-refundable tax credits include:
- The Child Tax Credit: Parents and guardians can receive up to thousands off their liability based on the number of children they have. Similarly, parents who adopt a child and caretakers of elderly dependents can also receive tax breaks.
- The Saver’s Credit: This includes all eligible contributions to your employer-sponsored retirement plan or traditional IRAs for self-employed individuals. This does not apply to Roth IRA contributions.
- The Lifetime Learning Credit: One of two education-focused tax credits, this credit allows you to reduce your tax liability when you pay tuition or school fees.
A tax deduction, on the other hand, is another type of tax write-off that reduces the amount of taxable income you have in the first place. Deductions include your business expenses (like your phone bill and mileage), as well as your donations and student loan interest payments.
Why Do I Need to Estimate My Tax Liability?
Anyone who does not pay withholding tax — which are tax payments employers send directly to the IRS on your behalf before depositing the rest of your salary into your bank account — must submit quarterly tax payments based on their estimated tax liability. This is because, just like traditional employees, you are legally required to have at least 90% of your estimated tax liability paid off before filing your tax return.
So what happens if you don’t meet the 90% mark? Underpaying your estimated taxes can lead to a financial penalty that can add up to a huge amount, depending on how much you missed the mark by. The penalty isn’t as harsh as if you completely forget to pay on time, but not meeting pay-as-you-go tax laws will still take money out of your pocket.
However, rest assured that you will have a bit of leeway. Because self-employed individuals rarely have a standard salary, the IRS adjusts for this with their safe harbor rule. This rule states that you won’t be penalized if you pay 100% of your previous year’s liability (110% if you earn over $150,000).
However, note that these numbers sometimes vary by year. Plus, if you live in a state that requires you to pay state taxes, which are included in your tax liability, you may be required to pay quarterly taxes. This makes it important to always read up on federal rules (and any state rules, which can vary tremendously) before setting up your quarterly taxes.
Regardless, fully considering how much you’ll earn in a year to estimate your tax liability will get you as close to or above the 90% mark as possible. You can use Form 1040-ES to calculate your estimated taxes as an individual, or Form 1120-W if you own a corporation. Online tax calculators can also help you out. If you’re truly unsure how much you’ll make after using these suggested guides, it’s always safer to pay more than you think you’ll owe, as you’ll receive a tax refund for anything you pay above your actual tax liability.
How to Pay Your Estimated Tax Liability
Without the benefit of tax withholding, independent contractors have to take a couple extra steps to actually pay your estimated tax liability.
First, you’ll want to divide your tax liability by four. This will get you the total estimated tax payment that’s due every quarter for the current tax year.
When quarterly payments are due, most taxpayers elect to pay online with their bank account using IRS Direct Pay. This is a highly secure, no-fee method you can complete from your laptop. Payments are also accepted via credit card, though this comes with a small fee.
However, you also have the options to pay by phone, check, money order, or cash. Just follow the directions outlined on Form 1040-ES, linked again here for quick reference. When doing so, always double check that you’re calling the correct phone number or ensure you’re placing your mail in a secure envelope and mailbox. Because these methods are subject to human error, the IRS highly recommends using the online payment method.
Frequently Asked Questions
Tax liability may feel like a huge responsibility, but when you have it broken down, it’s a simple part of the American tax system. To help you break it down further, here are our answers to some frequently asked questions.
1. When do I need to submit my estimated tax payments to fulfill my tax liability?
Your quarterly estimated tax payments are due on the following dates every year:
- April 15 for the first quarter
- June 15 for the second quarter
- September 15 for the third quarter
- January 15 of the next year for the fourth quarter
The only exception is if one of these dates falls on the weekend. If this occurs, the date will typically be moved to the following weekday.
2. Does every self-employed person need to submit estimated tax payments?
For the most part, yes. People who are self-employed (like rideshare drivers, freelancers, and small business owners) are typically required to submit these quarterly payments to avoid a penalty. S-corporation shareholders are also looped into the category. In addition, anyone who earns significant money from investments, alimony, or retirement will have to pay estimated taxes prior to Tax Day.
However, there are exceptions. For example, if you don’t earn enough to pay $1,000 in taxes ($500, for corporations), you typically don’t have to pay until tax season rolls around. Plus, you won’t owe quarterly taxes if you meet all three of these requirements:
- You are a U.S. citizen.
- You earned an income for all 12 months of a tax year (ex: January 2019 to December 2019).
- You didn’t pay taxes in the previous tax year. For example, if filing for 2019, you would meet this requirement if you didn’t pay taxes in 2018.
3. Do I still need to estimate my tax liability if I file taxes with an accountant?
Most accountants will assist you in calculating and setting up your quarterly estimated tax payments. However, we still recommend having a general idea of what your tax liability will be if you’re only planning to visit your CPA toward the end of the tax year. This is because self-employed individuals need to set aside income for taxes throughout the year. If you haven’t calculated your tax liability prior to your appointment with your accountant, you run the risk of owing more than you saved up.
Find No Surprises in Your Tax Return
Getting to know your taxes extremely well is all part of being self-employed. When you estimate your income and taxes long before filing your tax return, you won’t be surprised by any amount you owe or any deductions you qualify for. Even more importantly, you won’t be penalized by the government for not being prepared.
Want to learn more about how you can save on taxes? Some entrepreneurs qualify to deduct 20% of their earnings. Use our guide to learn about how qualified business income deductions can help you out.
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