How to not screw up your taxes

The next quarterly deadline for self-employed workers to file estimated taxes is approaching fast. Here's a survival guide for getting it right.

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By Rachel Kaufman, CNNMoney.com contributing writer

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WASHINGTON (CNNMoney.com) -- My name is Rachel Kaufman, and I don't understand taxes.

I thought I was doing everything right until tax season. That's when my tax prep software told me I owed thousands of dollars for my small - by all standards - writing business. Thousands I ... didn't exactly have. Sure, I'd been saving some money to pay the IRS, and I thought it'd be enough, but there I was, scrambling to find a hefty chunk of extra cash. About $2,000 extra.

I realized I didn't know as much as I thought I did.

More than 20 million businesses in the U.S. have no employees. Most are operated by independent contractors - and by all counts, that number is growing, as recently-laid off workers take the plunge into starting their own companies or stringing together freelance work. As you navigate the world of business licensing, marketing, and setting up that Web site or Twitter feed, don't forget to spare a thought for Uncle Sam.

My first mistake: Not saving enough throughout the year. "I think that setting aside money [each week] is an important, smart thing to do, but realistically, I don't think most people do that," says Kelly Phillips Erb, a tax attorney and a blogger at TaxGirl.com.

I tried to save. I'd heard the rule of thumb that says 30% to 40% of your gross income will go to taxes, and I dutifully set aside three-tenths of everything I earned ... until I looked at the account and realized I had thousands of dollars. No way could I need that much money!

I forgot - willfully, maybe - that W-2 employees have taxes withheld on each paycheck, so of course my tax bill as a self-employed person would be higher. I hadn't paid anything throughout the year, and it was all coming due April 15.

At least I wasn't alone. "There was one year where I took on a substantial contract," says Sherry Beck Paprocki, a Columbus-based writer who just co-authored The Complete Idiot's Guide To Branding Yourself. "When my tax bill rolled around, it was $8,000, and there went the front-porch reconstruction that we had planned for that year."

Second mistake: Misunderstanding estimated tax. The simplest way of thinking about it is this: W-2 employees "pay" tax every week through withholdings. Estimated taxes are "kind of the equivalent of your withholding," says Phillips Erb. If you don't pay estimated taxes, you'll be hit with penalties and interest.

Don't fall for the "wisdom" that says if you got a refund last year you don't have to pay estimated taxes this year. If you paid any tax last year - even if you got a refund - you owe estimated tax this year. The next federal deadline is June 15, and most states follow the federal calendar, but check with your own state's department of revenue.

But how? I'd tried the IRS's estimated tax worksheet and decided anything would be easier than filling out that form - another factor that led to my whopper of a bill in April.

"In 30 years of doing this, I have never, ever told an independent [contractor] to use the IRS tax worksheet. That tax form is confusing to every single indie that's out there," says June Walker, a Santa Fe, N.M., tax consultant who specializes in self-employment issues.

Instead, she recommends a simple approach: If you expect to owe more tax this year (because your business is growing, perhaps) than last year, pay what your total tax was last year, broken into four equal, quarterly installments.

Your last year's total tax includes tax you "paid" through withholdings at your job, if you're a newly-minted independent worker. As long as you pay 100% of your last year's bill (110% if your gross income was over $150,000), you won't owe any penalties come April 2010, but if you're earning more as an independent contractor than you did on a salary, you'll still have a tax bill.

For example, if you paid $1,000 in tax last year, as long as you send the IRS $250 every quarter, you won't owe any penalties even if you owe $2000 in tax this year. But you'll still have to come up with that extra grand in April.

My third mistake: Waiting until the last minute. E-filing your yearly tax return is easy - most tax prep software even walks you through it - but your first quarterly estimated tax payment is due on April 15, too.

I didn't realize the government uses a different system for online estimated taxes. EFTPS allows taxpayers to pay straight from a checking or savings account, like the high-yield, online account I had been using to stockpile cash for my taxes. I couldn't write a check straight from that account, but I figured I'd just debit the money.

But EFTPS takes about two weeks to activate after you register - the government needs to ensure you are who you say you are. Since I didn't have two weeks to spare, I floated a check from my regular bank account and hoped the funds transfer from my high-yield savings would arrive before the IRS cashed the check. It did, but I could easily have been slammed by bank overdraft fees and IRS penalties.

My fourth mistake: Being afraid to ask for help. "TurboTax is a tool," Walker says. "If you give one guy a hammer he can build the porch. Give another guy a hammer, and forget it - he's going to knock off his thumb."

Taxes are much more complicated for independent contractors and business owners than they are for traditional employees. If you need help, call in an accountant who knows the independent-worker laws inside and out. The money you spend on their fees may be offset by the time you save by not trying to master tax planning on your own.

I shelled out for TurboTax and spent hours poring over receipts and bank statements, but would I do that in 2010? I may be that person with the bruised thumb. I've got the credit card scars to prove it. To top of page

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