Why do people owe the IRS? Self Employed

I am an Enrolled Agent and have represented hundreds of people with Power of Attorney before the IRS. This had led me to think about why people owe. Today we’ll talk about the Self Employed, Self Employment Tax and Estimated Taxes

There are two types of self employed: Those that know they have a business and those who think they have a job but get paid with a 1099.

When you are employed (W2) your employer withholds money for income tax (W4) and they withhold 1/2 of your Social Security & Medicare. The contribute the other 1/2.

When you are Self Employed you must make your own Income Tax payments and since you are the employer and the employee and must pay both 1/2s  of your Social Security and Medicare (Known as Self Employment Tax this comes to 15.3% of your net income).

You make all of these payments as Estimated Taxes and the IRS expect them 4 times per year.

So one way people end up owing money is that they don’t even know that there are such things as Self Employment Tax or Estimated Taxes

Pocket Time Machine

When Summer ends Autumn comes and the weather turns cold. You go to your closet and get your coat or jacket.

Have you ever found money in the pocket? (I have). How did it make you feel? (It made me feel great)

This is how Saving works. You send money into the future. When you get there and find the money you feel great.

This is the whole philosophy: “A little and a little makes a lot”. Send good stuff into the future and you’ll be happy when you get there. If you send debt into the future it can be bleak.

Money in your pocket

When I was younger I would put my money in my pocket and then go about my day. After a bit my money would all be gone and I’d find myself wondering just where I had spent it all. I found that I could rarely account for it all and wondered if I hadn’t dropped some of it on the sidewalk.

This led me to think that if I couldn’t remember what I had spent it on I probably wouldn’t miss it if I set it aside up front and put it in the bank.

This is how I save money.

Retirement accounts

I’m always asking people if they are saving for retirement. Sometimes they say they’re invested in an IRA or 401k. Many of them think that those are investments and don’t realize they are just tax free vehicles(no tax consequences while the funds remain in the box).

Simply put there are two type of tax free vehicles: one where the money goes in before it is taxed and one where it goes in after it is taxed.

If the money went in before being taxed then it comes out  as regular income. If the money has already been taxed then it comes out tax free (unless they change the tax laws).

One idea is to have both tax deferred and after tax retirement accounts. This way you can take advantage of some tax savings up front and still keep you tax burden low during retirement since the regular income amount will be low.

Different kinds of Savings

When I talk about Saving I mostly mean for Retirement but there are other kinds.

You could be saving up for a car or a home or a trip to Europe. You should set up different accounts for different purposes. That way your Retirement account can remain inviolate. It’s important that you don’t think of it as money you can spend.

The Gym Dilemma

You’ve probably experienced this. You decide it’s time to go to gym and get in shape.

The problem is you work out too hard and in the next day or two are so sore that you don’t go back to the gym.

The same thing can happen with Saving. If you set aside too much of your income then you have to take money back out to pay your bills. This violates the bubble and your savings are no longer safe from being withdrawn.

So when it comes to saving you need to pick a doable amount.

Money is not important

Money is not important. It’s the lack of money that is important.

If you make enough money to pay your rent/mortgage, pay for food, utilities, clothes, cars, insurance, etc. If you can afford to fix things when they break and go to doctor when you’re sick then you have enough money. How would your life be meaningfully different if you made twice as much? Bigger house? Newer car? Nicer clothes?

If you don’t make enough money then things are very bad indeed. And many things end up costing you more.

If you don’t make enough money then you will be late making payments and you credit rating will go down. If your credit rating is low then you have to pay more for a lot of important stuff.

If your credit is good then you can get a car loan for 3% interest. The lender will finance up to 135% of the retail value of the car.

If you credit is bad then you could pay over 20% and the lender might loan only 80% of the WHOLESALE value of the car and charge a loan origination fee of $1,000.

When people have bad credit and need to borrow money they can pay hundreds of percent interest. A bad credit report can effect your ability to be hired for a job or to lease an apartment.