How To Avoid Filing Quarterly Estimated Taxes On Your Side Hustle
Growing up, I would never have imagined I’d own a business one day. No one in my family ever had a business, and the mere concept seemed foreign to me. I was a product of my environment, which was a lower middle class family in what was then working class Baltimore City. Life was pretty straightforward, you go to school and then try to get a job. In the environment of my childhood starting a business was only an option for people who had wealth.
Fast forward more years than I’d care to count, and here I am, a business owner.
Sure, it’s only a sole proprietorship, the simplest and easiest form of business to start. But it’s a business nonetheless. I was able to accomplish this largely because I freed up half of my week by going part time at my W2 job, and dropped my hours down to 20 a week. And of course I can afford to do that because I’m financially independent. FI is a powerful thing, it gives you options and opens up opportunities.
My business is doing graphic designs, both selling online and doing custom work. I kind of stumbled into it, and I still have a bit of imposter syndrome sometimes, but I love it.
My business income has been steadily increasing, which is great. But that’s also where the problems start, especially in regards to taxes.
Unlike a W2 job, when you make business income for yourself there are likely no taxes being withheld. The unfortunate reality is the IRS requires you to pay taxes on all income as you earn it throughout the year. That includes W2 income, or income from a business or freelancing.
There is what they call the “Safe Harbor” rule, which means if you expect to owe less than $1,000 in taxes after subtracting your withholdings during the year, you’re good. If you owe more than $1,000 when you file the next year, you could be penalized for underpayment.
I’ve always underpayed my taxes intentionally, choosing to pay the balance the next year at tax time. I’m not going to let Uncle Sam hold my money hostage and take an interest free loan from me. I choose to take an interest free loan from him.
Last year I made a few thousand dollars doing graphic arts. Nothing big, but since I didn’t pay taxes on that income during the year it added almost a thousand dollars to my 2018 tax bill. This year however will be a different story. I’m projecting to earn quite a bit more.
The Strategy
Most freelancers and business owners choose to file their taxes quarterly as they make their income. They file IRS Form 1040-ES four times a year and estimate what they owe from their business income. This is called paying estimated taxes, appropriately enough.
But if you still have a W2 job like I do and are making business or freelance income on the side, there’s another way. Instead of the hassle of paying quarterly taxes, you can simply increase your Federal tax withholding on your W2 paycheck to compensate for the taxes you aren’t paying on your additional business income. Of course this will only work if your business income is relatively modest like mine.
This strategy will work for a sole proprietorship, and an LLC with a single member since the IRS requires those two types of small businesses pay taxes on a personal tax return. In the case of a one person LLC it’s called a disregarded entity.
A good rule of thumb is to set aside about 30% of your business income for taxes. If your W2 income is on the high side of things and you’re already in the 32% or 35% Federal tax bracket, you’ll need to set aside more. For me, 30% is enough to cover my Federal and state taxes.
So if I earn $9,000 this year in business income I’ll need $3,000 set aside for taxes on that income. When taken out of my W2 paychecks – $3,000 divided by 24 checks is only an additional $125 per check.
This strategy will work as long as my business income stays pretty modest.
However if you’re lucky enough to be earning $90,000 in business income on the side of your W2 job, that means you’d have to ask your employer to take out an additional $30,000 or more in taxes to cover for it! If you get paid 24 times during the year that would mean an additional $1250 per paycheck – in addition to the taxes already being taken out for your W2 job.
Probably not a good strategy, even if your employer would let you do it.
That’s my strategy, plain and simple. My employer makes it easy to request additional money to be taken out of my paycheck for taxes. I can do it online and change it every paycheck if I wish.
I started this in January and my part time W2 paycheck already went down by $125, but those extra Federal tax withholdings will pay the taxes on my graphic arts income. And most importantly it will save me tons of time and hassle by letting me avoid filing estimated taxes 4 times a year.
Your Turn Readers – If you have business or freelance income and a W2 paycheck, have any of you tried this strategy, or do you just pay quarterly estimated taxes?
Great idea, Dave! I’m not at this point yet, but I’m hoping to be there eventually, and this strategy is both easy and doable. It seems so obvious, but I hadn’t considered it. One less thing to worry about. Thanks!
You’re welcome!
I just paid my quarterly estimated taxes the other day. I didn’t file form 1040-ES, though.
My income is modest for now from the blog, and I have friends who just increase their W2 taxes like you do, and it seems to work really well for them.
It’s really a good idea if you are a solo-entrepreneur.
TPP
I hope I can keep doing it for a while but then again I hope my side hustle income goes up a lot!
I have a similar strategy to yours Dave. I have no exemptions listed on my W2 so I have the max tax withheld each paycheck for my W2 job.
Despite this, because of all the passive income streams I have as well as income from blogging, etc (definitely not passive) this still is not enough. However I avoid the underpayment penalty because you can owe up to 10% of your total tax bill and not get hit with the fee (which gives me a lot of wiggle room given the amount of taxes I owe each year.
When the point comes that this too is not enough, then I would file a W4 and have even more money withheld.
Great minds… 🙂
And I’ve owed a ton before and never been penalized. I don’t think they patrol that too much.
we’ve done a number tax dances over the years. when mrs. smidlap was collecting unemployment a couple of years ago she didn’t have tax withheld so i just bumped up my withholding by what i calculated was close to net zero for us at tax time. these are good problems to have i guess.
They are problems of the good kind. Life could be harder. But then again, the tax code could be simpler too….
This is very helpful! My wife started a side gig last year and it continues to gain traction. We’ve reduced our withholdings this year to account for it – but may need to take that next step if things continue to grow. Thanks for sharing this.
Glad it helped, thanks for the kudos!
I wonder how many freelancers know that paying these estimates (or taxes at the end of the year) is a thing? I remember just starting out with side income and thinking it’d all be take home pay only to realize at the end of the year, that’s not the case. Solid post.
I currently am not earning much over $5-10k/year in side income so my strategy of strictly tracking side income-type expenses has helped to offset much of the tax burden. Once the income gets higher though, I’ll be in your boat of increasing my W-2 withholding (as the employer in that relationship, it’s a nice benefit to have).
Enjoyed this one, Dave. Thanks.
-Mike
I remember first starting out when I earned just some pocket change on the side – no big deal. But once that figure drifted toward the 4-figure range, I earned a nice little surprise come tax time.
Now, my side income hovers between $5-10k and I try to minimize my tax burden by tracking expenses and offsetting as much of the income as possible come tax time.
Either way – a great reminder and a great read. Thanks, Dave!
My side hustle income will come in around the same this year. And this strategy is an easy way to handle it without the hassle of filing every 3 months. I’m too lazy for that 🙂
When I was doing my taxes earlier this year for my side hustle income last year I learned quite a bit about all this self employed tax stuff. Long story short I came to this exact conclusion to just simply increase my W2 withholdings to cover any side hustle income taxes!
Even better is I was able to come up with an excel sheet to calculate out my exact projected tax liability for the year so I can track my withholding a against that. I tested it against prior years (with their old tax tables) and it all tied out which is pretty cool!
Smart folks always reach the same conclusion. And you have to pay taxes on that awesome scooter-charging gig you have going there!
I’m biting the bullet and pay the estimated tax. It’s easier than getting my wife to change her withholding.
Sounds like you’ve been over this, I’ll withhold comment 😉
I respectfully disagree with you in this regard. I think it’s far more advantageous to pay estimated taxes online with pay1040.com.
1) By allowing your employer to withhold more of your pay check, you are decreasing your opportunity to invest that money sooner. That $125 can be invested in the market every month. If being conservative, you can put it in high yield savings account earning 2-2.5% interest. By paying estimated taxes, you have a 4 month lag. And if paying with credit card, you have a 5 month lag (since credit card payments are generally due a month after billing statements). I think it puts more time on your side in terms of the time value of investing the money.
2) Paying estimated taxes online can actually result in a small profit. (I have an article about this.) If the fee to pay taxes online is 1.87% and you have a credit card that returns 2-3%, that’s not insignificant.
3) Additionally, paying estimated taxes online using a credit card can help you easily make the required minimum spending to earn a credit card sign up bonus. A great way to rack up the points/miles/cash credit card rewards!!!
4) Paying estimated quarterly taxes via credit card is very simple and easy. It’s definitely not “tons of time and hassle” as you refer to, at least I don’t think so.
Let me know what you think 🙂
I love disagreement Doc, especially when it’s done cordially. Unlike the rest of the internet 🙂
Although I don’t think our strategies are very different at all. You’re just doing the same thing I am except you’re doing it 4 times a year and I’m doing it once. What I mean by that is that in my strategy I still underpay my taxes during the year. And I do invest the extra I owe, so it’s not going to waste. However, I have to have some extra taken out of my W2 check to cover my side hustle income and avoid underpaying too much and getting penalized. I can’t just let it all go, it’d be too much.
So on April 15 (this Monday) I cut a big fat check to Uncle Sam for well over a thousand dollars. I underpaid by quite a lot but over the years I’ve learned how much I can do it and not get penalized. They don’t seem to enforce the penalty too much.
And yes, when I pay the taxes (this weekend), I use a reward card as you say and get rewarded pretty nicely simply for taking a loan from Uncle Sam and paying him back with a credit card. It’s just that you’re doing it 4 times and I’m doing it once in April. And BTW I thought about posting about this too, I’ll check out yours.
Where we do disagree is that doing this 4 times to me is a hassle. I’m just making one huge payment instead of 4 smaller ones. I don’t want to have to file the stupid paperwork 4 times during the year. I’ll forget for sure. First world problems 🙂
Thanks for the great comment, and stay tune for this coming Tuesdays post where I (again) go into the absurdity of getting a big refund.
I’ll definitely be looking out for Tuesday’s post!
Also… I was recently learning about presidential candidate Andrew Yang and how he talked about Universal Basic Income and how it could help people who will inevitably lose jobs to AI and automation– like Truck Drivers. I immediately thought back to your post a few weeks ago about autonomous cars and how being a truck driver the most common job in so many states.
Anyway, Yang’s predictions are a lot more aggressive than your hypothesis. He thinks it’ll happen sooner than we think and it could lead to Depression era unemployment and civil unrest.
YIKES!
Yang was on Joe Rogan (I believe) and it was interesting. He’s definitely tuned into tech and the future of AI.
We use this as well. No exemptions. When coupled with a high withholding rate on RSUs we end up with a tax bill under 100 most years.
Boo-yah!
While this strategy is focused on side gigs, its also very useful to use as one’s taxable dividends grow. I’ve used this for years to avoid dealing with the quarterly estimated.
The other thing to note is that I’ve (at times) not had this withholding be linear (or constant) through the year. My employer allows me to withhold a fixed dollar amount “extra” for both state and fed. During a few years I started getting worried about underpayment in August or September and just increased the withholding. Money is, as the saying goes, fungible.
Yes! It’s useful for dividends and also if you sell a mutual fund that’s not in a tax free account as I did last year. I reaped some nice cap gains that I’ll have to pay taxes on, so I’ll just bump the W4 withholding even more. Great comment!
I’ve done the W2 shuffle with a side gig but avoided the opportunity costs. I put aside the 30% in a savings account and every quarter changed my withholding to account for that amount as a one-time “take” or have even done it as it approached the amount of my paycheck. Then I lived on the amount in the savings account for that payperiod. Kept me out of trouble at the end of the year.
Sounds like you’ve got a great strategy, thanks for the comment!