I am a contractor, wondering how much money I should put away for next year's tax season.?

Question

Should I invest in a ~6 month CD or other plan to maximize profits? I make ~90K. Should I put away around 40% of the money I earn? What are my options?

Answer 1

Please ignore the answer above me! He has NO CLUE on tax law! If you follow his advice, you WILL pay added penalties and interest at tax time!

Your ONLY proper option is to make quarterly estimated payments using Form 1040ES. Taxes are due when the money is earned, NOT on the due date for the return! Wage earners cover this through withholdings. Self-Employed individuals MUST make quarterly estimated payments to avoid penalties and interest for underpayment of taxes.

The SE tax itself is 15.3% on the net profit from the business activity. Income tax varies from 10% to 35% of taxable income. You'll need to crunch some numbers based upon your projected earnings to determine how much you must pay each quarter. As your income increases or decreases you can adjust the payments so that you arrive at the proper amount when you tax return is due.

If your state has an income tax, you'll need to make quarterly payments to the state as well.

If you just "salt" the money away and don't make the quarterly estimated payments as required by law, you WILL have penalties and interest added on when you file your return.

Addendum: In response to your e-mail:

You can make a deposit to an IRA for 2006 anytime up to the due date for your return and that will reduce your taxable income for 2006. However, a MUCH more appropriate solution for a self-employed person would be a SEP plan.

An IRA is limited to $4k per year but a SEP is limited to $40k per year! Any investment firm can help you set that up; I've always got good service from Edward Jones but they're hardly the only game in town. I'm not sure if you can still make a SEP deposit for 2006 but you can certainly include that in your future tax planning.

If you didn't make estimated payments during 2006, you'll have to bite the bullet on the penalties and interest for 2006. About the only thing you can do now is to stop the clock by making the January 15, 2007 estimated payment (the last one for 2006) right now. Then file when you can, but no later than April 17, 2007. You'll save a couple month's worth of interest on the underpayment that would accrue between now and when you do file.

You'll also need to make your first estimated payment for 2007 by April 17, 2007. The other three payments are due on 6/15/2007, 9/17/2007 and 1/15/2008.

Here's a link to the 1040ES package: http://www.irs.gov/pub/irs-pdf/f1040es.pdf It includes instructions,tables and worksheets to help in arriving at the correct amounts to pay.

Answer 2

You are required to make quarterly estimated payments. If you don't, you can be subject to penalties for under-withholding when you file your return, even if you pay all amounts due with the return.

40% should probably more than cover it for federal, including the 15.3% self employment tax. Depending on where you live and your personal situation, that might or might not cover your state tax liability also.

Answer 3

a good rule of thumb is 25-30%...but 40% is definitly safe. I would put it in a good money market account....you can earn about 5% and it is totally liquid...but remember that money is for Uncle Sam and nothing else. And if you over save atleast you made a little interest on it....