Paying taxes as a solo 1099 federal sub-contractor
As an employee, your employer withholds taxes from your paycheck on your behalf and the only time you would really have to think about taxes is when you filed your tax return.
No longer! Now you’ll have the privilege of paying the government the taxes they use to pay for your 1099 income!
» Estimated Taxes
As a self-employed individual, you will have to pay “estimated taxes” every quarter. The general principle is that at the beginning of every year, you will need to estimate how much in taxes you will owe the government based on projected earnings. Then you divide that number by four and then pay a quarter of what you think you owe ever three months or so.
The deadline for federal estimated tax payments are below:
- First Quarter: April 15
- Second Quarter: June 15
- Third Quarter: September 15
- Fourth Quarter: January 15
Lets say you project you will have a federal tax liability of $40,000 for 2021. You will pay $10,000 on April 15th, $10,000 on June 15th, etc.
Note that if your state has income tax they will probably have a similar estimated tax payment requirement and schedule and you will need to pay them as well.
Set a calendar reminder so you don’t forget to make the payment or else you might incur a penalty.
» How to estimate your tax liability
There are two approaches you can use: a 30% rule-of-thumb approach or a more precise calculator approach.
If you don’t want to do a detailed income projection, just set aside 30-35% of the payments you receive as you receive them and then pay whatever you have accumulated at the next estimated tax deadline.
Let’s say you received payments totaling $50,000 from Jan 1 - Mar 31. Using the 30% rule, you would have set aside $15,000 for taxes. On April 15, you will pay the IRS $15,000. Then you just repeat the process for the next three deadlines.
There is a good chance you will have overpaid or underpaid. There is no penalty for overpaying; when you will file your tax return you will get the money back.
If you underpay by a certain amount (I think less than 90% of what you owe) you might face a penalty, but it is pretty small. The bigger problem is if you didn’t set aside enough in taxes and you have to make a big payment to the IRS on April 15th.
Generally speaking, 30% probably gets you in the ballpark of the correct estimated federal tax liability and might even be a little a conservative.
Remember that if your state requires estimated tax payment you need to set aside funds for that too.
The more precise way to estimate your tax liability is to find an online tax liability calculator. If you Google “tax calculator” there will be many options you can use.
You will fill your project self-employment income, any income you or your spouse has, etc.
Then it will spit out your total tax liability. You can take that figure and divide it by four (or the number of estimated tax payments remaining in the year) to get your estimated payment amounts.
It’s up to you which method you use. After your first year in business and after filing your tax return you will have a better sense of what your effective tax rate is.
» How to make the payment
The IRS has a web page for payments that lists all the options you have to make payments. You can do a direct bank transfer or make a payment with a credit card or debit card.
Don’t mail a check. It’s annoying to wonder if/when your check is going to get delivered and cashed.
When you make your online payment, make sure you save a copy of the payment confirmation for your records so you know how much you have paid and in case the IRS claims you didn’t pay them.
For state tax payments, just Google “[Your state] estimated tax payments.” I’d imagine most states have online payment options by now. Governments can be very helpful when they want to get your money!
» Paying taxes with credit cards
Paying taxes with your credit card has a few advantages. First, if you’re in a temporary cash flow crunch, it buys you a little bit of time.
The second and main reason why I have used credit cards for my tax payments is to get credit card points!
For example, credit cards usually have a minimum spend amount to get a sign-up bonus. Say, spend $3,000 to get 50,000 points. I might value those points at around $750. Instead of switching my daily spending to a new credit card which I find a bit of a hassle, I make a single payment to the IRS of $3,000 and knock it out in one shot.
Yes, there is a 2% fee to use a credit card. But that is only $60 (and you can deduct it as a business expense so effectively only $45 or so). This means my total points “profit” is about $715. Paying the $45 to not have to worry about hitting the minimum credit card spend is worth it to me.
It may not be to you, but I wanted to highlight a personal benefit I’ve received from paying estimated taxes with a credit card.
» Filing your tax returns
Filing your tax return as a self-employed individual is not too different than when you did it as an employee.
The main difference is that instead of all your earnings information being neatly summarized in a single W2 statement you receive from your employer in January, you will receive a 1099-Misc tax form from the prime contractor with the amount they have paid you in the previous tax year.
If you did a good job of keeping track of your revenue, expenses, 401k contributions, and taxes, filling out the 1040 (the tax return form) should be a piece of cake.
Use TurboTax or similar software to save time. They all have fields to account for self-employment income that is tied to the “Schedule-C” forms that are part of your tax return.
I did not use an accountant to do my tax returns when I was a solo 1099 since tax software made it simple enough for me to do it on my own. I do use an accountant now because my income flows through a partnership, which is a different business structure with heavier administrative burden.
It is up to you if you’d rather use an accountant. Your accountant is still going to ask you to organize and provide all your self-employment income anyway which is 95% of the work.
» Reducing your tax liability with a Solo 401k
You may be a bit shocked by how much you owe in taxes. Some of the reasons are psychological. When you make big quarterly payments to the IRS for tens of thousands of dollars, it feels more real then when you have taxes withheld from your paycheck every two weeks.
There were also taxes on your income that you didn’t see. For example, as a W2 employee, you saw that you paid FICA taxes of about 7.65%. What you didn’t see was that your employer also paid 7.65% of your salary on top of that. As a self-employed 1099 federal sub-contractor, you get the pleasure of paying that too!
So you may find that you want to keep more of your income and reduce your tax liability. I am NOT a tax expert so I don’t know all the ways you can do so.
However, one big and relatively simple way to reduce your tax liability (or rather, defer it) is to open a Solo 401k.
If you’re not familiar with what a 401k is, it is a type of tax-advantaged retirement account typically provided by your employer. You can contribute up to $19,500 of your salary if you’re under 50 years old and $26,000 if you’re over 50. Under a traditional pre-tax plan, you won’t pay taxes on the amount of your contributions. If your marginal tax bracket is 24% and you contribute the full $19,500, you will reduce your tax liability for the year by $4,680.
What is cool as a 1099 is you can set up what is called a Solo 401k. The Solo 401k is a 401k for sole proprietors (and in some cases, their spouse).
It is pretty much the same tax favored 401k vehicle that your employer had, except you can make both “employee” contributions (that is you) and “employer” contributions (also you).
You can continue to make the same $19,500 contribution and make additional employer contribution up to a combined limit of $58,000!
Now, the rule is technically that you can contribute up to 25% of your net self-employment income as the employer contribution. So if you make
$100,000 net, you can contribute $25,000. To max it out you’ll need to earn (again, net) around $200,000.
So let’s say you earn $200,000 and max out the solo 401k of $57,000. If you are filing as a single person, your marginal tax bracket is 32% in this scenario. 32% * $57,000 is $18,240. So you can reduce your tax liability by $18,240. Pretty good!
It’s something you should consider if you are interested in reducing your tax liability.
I set up my Solo 401k through Vanguard. They are not the most technologically savvy, but despite having to mail in some forms initially to set it up, it has been pretty easy to manage. You can make contributions online and they will e-mail or mail you the relevant tax forms at the end of the year.
I have also heard some good things about Fidelity so that might be an option worth considering.
If you have questions feel free to reach out to me directly at firstname.lastname@example.org. I can also add you to my informal mailing list in case I have updates or news or whatever.
This article is an excerpt from Chapter 11 (How to operate your business like a minimalist) of my book.
You can read more about it here: