Being your own boss can be very rewarding both financially and spiritually, but there are challenges associated with freelance work.
Taxes are one of the most difficult aspects because self-employment brings a special set of tests.
Freelancers work as independent contractors and those who employ them are not required to withhold payroll taxes (Medicare and Social Security contributions). As both employer and employee (technically, you employ yourself), you must contribute both sets of taxes — the normal income tax that you would pay on your income as an employee and the "self-employment tax" that covers Medicare and Social Security contributions.
You must estimate and pay this tax quarterly to approximate the monthly flow of payroll taxes that the government would receive from an employer. Estimated taxes are due on the 15th of the month after the end of the quarter. For example, taxes for the first quarter of January 1 to March 31 are due on April 15 (or the next business day if the 15th falls on a weekend or holiday). Failure to make payments on time will result in penalties and interest charges on the unpaid taxes.
Every person that you work for as an independent contractor is obligated to file a 1099 form with the IRS and send a copy to you as a record of your earned income. Keep close track of these 1099 forms, as they serve as proof of your income. Even if you are not supplied with a 1099 form that corresponds to one of your freelancing jobs, you are obligated to report that income. If the IRS finds a 1099 form that does not correlate to your reported income, expect greater scrutiny of your tax return.
Quarterly payments are made by filing Form 1040-ES, "Estimated Tax for Individuals. The form contains a worksheet to help you estimate your taxes and the address to which you mail your completed form and payment (based on where you live). If you have questions, the IRS has a section of their website devoted to tax issues for the self-employed.
Keep in mind that you are paying taxes on your profit, not your income. To determine your profit, subtract your business income from your business expenses. If your net profit is over $400, you will need to file an income tax return, and if you are expected to owe $1,000 or more in total taxes, you will need to make estimated quarterly tax payments.
Since you are an independent contractor, your tax deduction options are a bit different since you have business-related deductions available to you. A list of some of the more popular ones is available here.
In essence, you should put aside a portion of your self-employment income as it comes in (around 15%-16% of income) and devote it to your expected quarterly tax bill. Too many factors come into play for you to put away the correct amount out of each paycheck accurately, but there are online calculators available to help you estimate your taxes based on your expected income and profits. Run an early estimate and keep a conservative amount in the bank to cover payments.
After a while, self-employment taxes will become routine. Just keep reminding yourself that self-employment taxes are one of the things you have to put up with for the enjoyment of being your own boss and awarding yourself a vacation day whenever you feel like it.
More from Money Tips
Total credit cars debt passed $70 billion in 2015
The 8 big mistakes in planning for your taxes
Do you qualify for an Earned Income Tax Credit?