(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The self-employment tax is a tax that gets added to your normal income tax. The tax is calculated by multiplying your earnings from self-employment by approximately 15%.

Why the Self-Employment Tax Exists

At first glance, it seems unfair that entrepreneurs — the most important driving force behind our economy — would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.

If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the fact that part of your income was withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the Social Security and Medicare taxes.

The way these taxes are structured, the burden is shared equally between the employee and the employer. The employee’s share is calculated as 6.2% of the employee’s wages for Social Security tax and 1.45% for the Medicare tax. At the same time, the employer also pays both taxes, calculated at the same rate. As a result, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for Social Security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for the Medicare tax.

Given that you are self-employed, there is no employer with whom you can split the burden. You are therefore responsible for paying both halves of the Social Security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the self-employment tax.

How to Calculate Your Self-Employment Tax

As long as your “net earnings from self-employment” are $400 or more, you will be responsible for paying the self-employment tax — calculated as 15.3% of your net earnings from self-employment.

To calculate your net earnings from self-employment, subtract your business expenses from your business revenues, then multiply the difference by 92.35%. (This odd multiplication figure is the result of the fact that you’re allowed to deduct 50% of your self-employment tax when calculating the income upon which the tax will be charged.)

It’s important to note that the 12.4% Social Security tax only applies to the first $142,800 of earned income per year. (This limit is updated annually. The figure here is for 2021.) The 2.9% Medicare tax, however, does not have a limit.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The Importance of Business Expenses (Schedule C Deductions)

Now that you’re self-employed, you have an additional, extra-valuable level of deductions: business deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and thus your regular income tax), but also your earnings from self-employment, thus reducing your self-employment tax as well.

From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thereby saving you even more money.

In order for an expense to be deductible for your business, it must be both “ordinary” and “necessary.” The IRS considers an ordinary expense to be one that is both common and accepted in your field. A necessary expense is one that is helpful and appropriate for your business. (Note that this means that an expense does not have to be absolutely indispensable for it to be considered necessary.)

Deduction for One-Half of SE Tax

Each year, when calculating your income tax, you are allowed a deduction (specifically an “adjustment to income”) equal to 50% of the amount you pay as self-employment tax.

Simple Summary

• The self-employment tax exists simply to take the place of the Social Security and Medicare taxes that you and your employer would be paying if you had a job as an employee.
• The tax is calculated as 15.3% of your net earnings from self-employment (or 2.9% for amounts beyond the annual maximum amount subject to Social Security tax).
• Business deductions (sometimes called Schedule C deductions) are more valuable than either adjustments to income or itemized deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your self-employment tax.
• Each year, you are allowed an adjustment to income (i.e., a deduction) equal to 50% of the amount you pay for self-employment tax.

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more noteworthy options:

1. Simplified Employee Pension (SEP IRA),
2. Savings Incentive Match Plan for Employees (SIMPLE IRA), and
3. Individual 401(k) — sometimes called a solo 401(k) or a self-employed 401(k).

Much of the IRS literature comparing these three options is rather complicated. Fortunately, most of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is the contribution limit for each. (Note: These limits are not cumulative, so there’s usually no benefit to opening more than one retirement plan for your business.)

If you do have employees and you want to set up a retirement plan for your business, I strongly recommended that you consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting and nondiscrimination requirements as well.

I should also note here that there are several other types of retirement plans aside from the three listed above. But for self-employed taxpayers without employees, it’s uncommon for any of the other types of plans to be a better choice.

Retirement Plans in General

Most of the retirement plan options for self-employed taxpayers function similarly to a traditional IRA. That is, contributions made to the plan reduce your taxable income, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, contributions are adjustments to income (i.e., “above the line” deductions) rather than Schedule C deductions, meaning they save you money on income tax but not self-employment tax.

SEP IRA

SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an adjustment to income for any contributions you make, and distributions from the account are taxable as income. The only really important difference is the contribution limit. For 2021, if you have a SEP, you are allowed to contribute the lesser of:

1. 20% x (your business’s profit, minus the deduction for one-half of your self-employment tax), or
2. $58,000.

Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.

EXAMPLE: Your business’s profit for the year is $100,000, and your deduction for one-half of your self-employment tax is $7,065. Assuming you do not contribute to another retirement plan for your business, your annual SEP contribution will be limited to $18,587, calculated as 20% x ($100,000 — $7,065).

SIMPLE IRA

SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make:

1. An employee contribution of $13,500 for 2021 (plus an employee catch-up contribution of $3,000 for 2021 if you are age 50 or over), limited to 100% of your net earnings from self-employment, plus
2. An employer contribution equal to 3% of your net earnings from self-employment.

For SIMPLE IRA purposes, “net earnings from self-employment” is your business’s profit, times 92.35% (to approximately account for your deduction for one-half of your self-employment tax).

EXAMPLE: You’re under 50 years old, and your net earnings from self-employment is $50,000. Assuming you don’t contribute to any other retirement plans, the most you’ll be able to contribute to a SIMPLE IRA is $15,000 ($13,500, plus 3% of $50,000).

One other difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).

Individual 401(k) Plans

An individual 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. Specifically, you are allowed to make:

1. An employee contribution of $19,500 for 2021,
2. An employer contribution equal to 20% of your net earnings from self-employment, and
3. A catch-up contribution of $6,500 for 2021 if you’re age 50 or older.

In this case, your net earnings from self-employment is defined as your business’s profit, minus the deduction for one half of your self-employment tax.

However, there are a few additional limitations to the above contributions. Specifically:

• The employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution,
• The employee and employer contributions are limited to a combined total of (for 2021) $58,000, and
• The total contribution is limited to your net earnings from self-employment.

Also, as we’ll discuss shortly, if you have another job (i.e., a “day job”), your maximum employee contribution and catch-up contribution will be affected if you make contributions to a retirement plan at that other job.

There’s obviously a lot going on here. Fortunately, you can use the “Deduction Worksheet for Self-employed” from IRS Publication 560 to walk you through the math. I’ve also made a solo 401(k) calculator that you can use.

EXAMPLE: You’re under 50 years old, and you have a business with no employees. Your net earnings from self-employment are $100,000 for 2021. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $39,500 calculated as follows:

• Employee contribution of $19,500, plus
• Employer contribution of $20,000 (20% of $100,000).

If you had a SEP IRA instead, your contribution would be limited to $20,000 (20% of $100,000). Alternatively, if you have a SIMPLE IRA, your contribution limit would be even lower ($13,500 plus 3% of net earnings from self-employment).

The conclusion here? In most circumstances you can contribute more — sometimes much more — to an individual 401(k) than you could contribute to a SEP IRA or SIMPLE IRA.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

Individual 401(k): Roth Option

In addition to usually allowing for greater contributions, individual 401(k) plans have another benefit: If you would prefer to do so, you can make Roth contributions to an individual 401(k) rather than pre-tax (“traditional”) contributions.

Note, however, that many brokerage firms do not allow for this option, so be sure to check with the brokerage firm you’re considering if it’s important to you to be able to make Roth contributions.

If you decide to open an individual 401(k) with a Roth option, it’s important to know that only the employee and catch-up contributions (those limited to $19,500 per year and $6,500 per year for people 50 or older) can be Roth contributions. The employer contributions must be made as traditional, tax-deferred contributions.

Is an Individual 401(k) Always Best?

Given the dual advantages of Roth contribution capability and (usually) higher contribution limits, one might wonder why anybody would choose a SEP or SIMPLE IRA over an individual 401(k).

Previously, a significant disadvantage to individual 401(k) plans was that they came with higher administrative costs. Over the last several years though, price competition has brought costs down considerably at some brokerage firms. For example, Fidelity’s individual 401(k) has no set-up or administrative costs at all. Similarly, Vanguard’s individual 401(k) has no set-up fees and only a modest administrative fee: $20 per year for each mutual fund in the plan — and this fee is waived if you have at least $50,000 of assets with Vanguard.

Given the decline in costs, the only real remaining drawback is paperwork. Setting up an individual 401(k) will likely require you to fill out more forms than opening a SEP or SIMPLE IRA. In addition, individual 401(k) plans require  you to file Form 5500-EZ with the IRS every year once the plan reaches $250,000 in assets.

Deadlines for Retirement Plans

A SEP IRA or individual 401(k) can be set up as late as the due date (including extensions) for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension).

Assuming you’ve never had one before, a SIMPLE IRA can be set up as late as October 1 of the first year for which you wish to make contributions. (If you have had a SIMPLE IRA before and are setting up another one, you must set it up by January 1 of the first year for which you wish to make contributions.)

For a sole proprietor, the deadline for SIMPLE IRA employee contributions is January 30 of the following year. The deadline for the employer contribution is the due date (including extensions) for the business’s tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

What if You Have Other Retirement Accounts?

Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. None of the above-mentioned plans will affect your ability to contribute to a traditional or Roth IRA. They could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have one of the business retirement plans described above, you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.

In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) at that job, contributions you make to your plan at work — to take advantage of an employer matching contribution for instance — will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA. And the same goes for catch-up contributions. (That is, catch-up contributions made to your plan at work will count against the catch-up contribution limit for your individual 401(k) or SIMPLE IRA.) And it works in the other direction too — employee and catch-up contributions you make to an individual 401(k) or SIMPLE IRA will count against the contribution limits for your plan at work.

EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Her net earnings from self-employment are $40,000.

To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $15,500 ($19,500 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment).

Simple Summary

• As a business owner, you have several options for retirement plans. In most cases, contributions to these plans reduce your taxable income.
• In most cases, an individual 401(k) plan will allow for the largest contribution. In addition, individual 401(k) plans allow for Roth contributions (though this is not available at all brokerage firms).
• SEP IRAs and SIMPLE IRAs, however, can sometimes be good choices because of their simplicity.

For tax years 2018-2025, there is a deduction for pass-through business income (i.e., income from sole proprietorships, partnerships, S-corporations, or LLCs taxed as any of the above).

What follows is my best attempt to explain the deduction clearly. Unfortunately, it is complicated. So if this deduction is relevant to your personal tax planning, I’d encourage you to meet with a tax professional and read the applicable Code section for yourself.

One point before we get started: I’m simplifying here by assuming that you have no qualified cooperative dividends, qualified REIT dividends, or qualified publicly traded partnership income. Each of those types of income gets special treatment under this new Code section.

Basic Calculation

If your taxable income* is under a certain threshold amount, the deduction is 20% of the pass-through income from your business(es), but it cannot be greater than 20% of your taxable income excluding net capital gains.

The threshold amounts for 2021 are $329,800 if you are married filling jointly, $164,925 if you are married filing separately, or $164,900 if you are single or head of household. (Of note, this is roughly the top of the 24% tax bracket for each filing status.)

When your taxable income exceeds the threshold, two potential complications kick in:

• A wage (or wage + property) limit, and/or
• A phaseout for “specified service businesses.” 

Wage (or Wage + Property) Limit

If your taxable income exceeds a certain phaseout range (i.e., the threshold amount from above, plus $100,000 if married filling jointly or $50,000 if single/head of household/married filing separately), then your deduction for each business will also be limited to the greater of:

• 50% of the W-2 wages paid by the business**, or
• 25% of the W-2 wages paid by the business**, plus 2.5 percent of the unadjusted basis immediately after acquisition of all “qualified property” (basically, depreciable tangible property that is used by the business or held by the business and available for use).

If your taxable income is in the phaseout range, the calculation basically says, “If you were past the phaseout range, how much would the wage (or wage + property) limit reduce the amount of your deduction? Now, instead of reducing your deduction by that whole amount, we’ll multiply that reduction by a percentage that is the percentage of the way you are through the phaseout range.”

Example: You are single and in 2021 you have $150,000 of pass-through income from a sole proprietorship. Your taxable income is $189,900 (i.e., halfway through the phaseout range). The business has no qualified property. The business has two part-time employees to whom it paid a total of $40,000 of W-2 wages over the course of the year.

Without regard to the limitations, your pass-through business income deduction would be $30,000 (i.e., 20% of $150,000). But your taxable income is past the threshold amount of $164,900. If you were past the phaseout range, your deduction would be limited to $20,000 (i.e., 50% of the wages paid by the business). That’s a $10,000 reduction relative to what it would be without the limitation.

But you aren’t past the phaseout range. You are halfway through it. So your deduction ($30,000) is reduced by half of that $10,000 — for a total deduction of $25,000.

Specified Service Business Phaseout

If your business is a “specified service business,” there’s another limitation that can come into play. A specified service business is:

• Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees; or
• Any trade or business which involves the performance of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

If your business is a specified service business, then we again calculate how far your taxable income is through the same phaseout range (i.e., the same threshold, plus either $100,000 or $50,000).

If you are past the phaseout range, you get no deduction for pass-through business income.

If you are in the phaseout range, then we calculate the deduction as normal, except we only consider a pro-rata share of all of the amounts from the business (income, gain, deduction, loss, W-2 wages from the business). So, for example, if your income is 70% of the way through the phaseout range, everything is 70% phased out, so only 30% of your income from the business would be counted for calculating the deduction.

A key point here is that this affects the amount of wages counted for applying the wage and wage+property limits! And this is where the complexity starts to get ugly.

Example: You are single and in 2021 you have $150,000 of pass-through income from a sole proprietorship. Your taxable income is $177,400 (i.e., 25% of the way through the phaseout range). The business has no qualified property. The business has two part-time employees to whom it paid a total of $40,000 of W-2 wages over the course of the year. The business is a specified service business.

Because you are 25% of the way through the phaseout range, all of the amounts from the business are 25% phased out, meaning we use 75% of each of them. So instead of calculating 20% of the income from the business, we calculate 20% of 75% of the income from the business (i.e., 20% of 75% of $150,000). That gives us a deduction of $22,500 before applying the wage-related limit.

As in the prior example, to apply the wage-related limit, we calculate what the reduction to the deduction would be if you were all the way through the phaseout range, then we apply only a portion of that reduction, based on how far you are through the phaseout range.

Again, the wage limit is 50% of the wages from the business, but because of the specified service business phaseout we are now calculating 50% of 75% of the wages from the business (i.e., 50% of 75% of $40,000). That gives us a limit of $15,000. That’s what the limitation would be if you were past the phaseout range. Relative to the $22,500 deduction you’d have without the wage limit, that’s a $7,500 reduction.

But you aren’t past the phaseout range. You’re 25% of the way through it. So we calculate 25% of the $7,500 reduction, which gives us a reduction of $1,875. So we take your initial $22,500 deduction and reduce it by $1,875 for a total allowed deduction of $20,625.

Other Assorted Points of Note

The deduction for pass-through business income is not an “above the line” deduction (i.e., it does not reduce AGI). But it is also not an itemized deduction; that is, you can claim it as well as the standard deduction. In other words, it works much like personal exemptions did prior to 2018.

As far as tax planning thoughts, I’ll offer three brief points:

• For business owners below the phaseout range, this deduction is usually a point in favor of keeping sole proprietor taxation (or partnership taxation) rather than electing S-corp taxation, as the wages that the S-corp would have to pay to owner-employees would not be pass-through business income.
• Business owners below the phaseout range will have two different marginal tax rates for different types of income. (Normal taxable income will have a normal marginal tax rate, and pass-through business income will have a lower marginal tax rate because it results in a larger deduction.)
• For business owners in the phaseout range, those two marginal tax rates will be higher, because each additional dollar of income (whether from the business or not) will cause partial phaseout of the deduction.

*For brevity’s sake, I’m referring to “taxable income” throughout this article. In reality, we are concerned with taxable income without regard to the deduction for pass-through business income.

**For multiple-owner pass-through businesses (i.e., partnerships, S-corps, or LLCs taxed as either of the two), “W-2 wages” only includes that one owner’s allocated share of total wages paid. For example, if the business paid $60,000 of wages and there are two partners each with 50% ownership, $30,000 would be the amount of wages each partner would use when calculating the deduction.

For the most part, handling the taxes for a sole proprietorship is fairly simple. It comes down to filling out just a few forms.

“Pass-Through” Taxation

Sole proprietorships are known as “pass-through” entities. What this means is that the profit (or loss) from the business is “passed through” to the owner of the business. Therefore, if you run a sole proprietorship, the profit from the business will show up on your regular individual tax return (Form 1040).

Schedule C

Schedule C is where you will compute the profit or loss from your business. Schedule C is little more than a list of all your revenues followed by a list of all your expenses. The end-result of Schedule C is a figure known as your “Net Profit or Loss,” which will be carried over to your Form 1040 and taxed at the regular individual income tax rates.

The Self-Employment Tax

In addition to being subject to regular income tax, earnings from a sole proprietorship are subject to the self-employment tax. This tax is calculated (on Schedule SE) by multiplying your net earnings from self-employment by 15.3%.

At first glance, it may seem unfair to subject somebody to an extra tax simply because they are self-employed. However, the self-employment tax is really just a substitute for the Social Security and Medicare taxes that are paid on salaries and wages for employees.

For employees, a Social Security tax of 6.2% and Medicare tax of 1.45% are withheld from each paycheck. Then the employer is required to pay a matching amount. As such, the employee is paying 7.65%, and the employer is paying 7.65% for a grand total of 15.3%. When you run a sole proprietorship, however, there is no employer with whom you can split the bill. As a result, you’re stuck paying the entire 15.3%.

There’s a maximum amount of earnings that can be subject to Social Security tax each year ($142,800 in 2021). So for earnings above that threshold, the self-employment tax rate is only 2.9% (i.e., just the Medicare tax rate) rather than the whole 15.3%.

Deduction for One-Half of Self-Employment Tax

Because you’re paying an additional tax (i.e., the half of Social Security and Medicare taxes that your employer would be paying if you were an employee), Congress decided it would be fair to allow you to claim a deduction (specifically an “adjustment to income”) for the extra tax paid.

Deduction for Pass-Through Income

For tax years 2018-2025, if you have income from a “pass-through” business such as a sole proprietorship, you may qualify for a deduction equal to 20% of your income from the business, subject to several limitations.

Simple Summary

• Sole proprietorships are known as “pass-through” entities because the income from the business is passed through to the owner, showing up eventually on his or her Form 1040.
• The profit or loss from a sole proprietorship is calculated on Schedule C.
• Earnings from a sole proprietorship are subject to the self-employment tax in addition to being subject to regular federal income tax. The self-employment tax is calculated as 15.3% of your net earnings from self-employment (2.9% for earnings above the annual maximum for Social Security tax).
• Schedule SE is the form used to calculate the self-employment tax.
• For tax years 2018-2025, you can claim a deduction equal to 20% of your income from “pass-through” businesses, including sole proprietorships (subject to several limitations).

The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.

The Federal income tax is what is known as a “pay-as-you-go” tax. This means that people and businesses are required to pay taxes as they earn income throughout the year. For anybody who is an employee, this is easy. In fact, it’s done automatically in the form of withholding from employees’ paychecks. However, things work differently for business owners. When your customers pay you for your products or services, there’s obviously no money withheld to go toward income taxes.

The government’s solution is to require you to make tax payments at approximately quarterly intervals throughout the year. These payments are known as estimated tax payments, because the amounts you pay are based upon an estimate of your total tax liability for the year.

How to Calculate Your Estimated Taxes

Sole proprietors use a worksheet that accompanies Form 1040-ES to calculate their required estimated tax payments. Generally speaking, the amount of estimated tax you are required to pay for the year is the smaller of:

1. 90% of your tax for this year, or
2. 100% of your tax from last year.

Given the inherent difficulty in predicting what your tax liability is going to be before you know for certain what your business income will be, it’s generally recommended to make estimated tax payments based upon the “100% of last year’s total tax” option. Assuming you use this option, each of your four payments will generally be equal to 25% of the total tax you paid last year.

There is an exception for high-income taxpayers: If your adjusted gross income was $150,000 or more last year, instead of being able to base your estimated payments on 100% of last year’s total tax, you will be required to base your payments on 110% of last year’s total tax.

Due Dates for Estimated Taxes

Self-employed taxpayers are required to make four estimated tax payments each year. The due dates are as follows:

• First payment is due April 15.
• Second payment is due June 15.
• Third payment is due Sept. 15.
• Fourth payment is due January 15 of the following year.

Note that this isn’t every three months exactly. Don’t make the mistake of assuming it’s quarterly, or you’ll end up making your second payment on July 15, and it will be a month late.

Also, please be aware that this means that on April 15, not only is your annual filing for the previous year due, but your first estimated payment for the current year is due as well. For instance, on April 15, 2022, a self-employed taxpayer will be required to file her Form 1040 for 2021 as well as make her first estimated tax payment for 2022.

The one exception to these due dates is for the January 15 payment. A taxpayer can skip the January 15 payment if, by January 31, he files his Form 1040 and pays his remaining taxes for the year just completed.

Consequences of Not Making Estimated Tax Payments

The penalty for underpayment of taxes is calculated as a function of current Treasury Bill rates, so it varies from year to year. The penalty for 2020 was figured at an annual rate of approximately 3%.

Simple Summary

• In contrast to employee-taxpayers who have taxes withheld from every paycheck they receive, self-employed taxpayers have nothing withheld when they receive payments from clients. Instead, self-employed taxpayers are required to make four payments of estimated taxes each year.
• Estimated tax payments for each year are due on April 15, June 15, September 15, and January 15 of the following year.
• Generally, the easiest way to avoid penalties for estimated taxes is to make each of your four payments equal to 25% of the total tax you paid last year (or 27.5% for high-income taxpayers). This will ensure that your estimated tax payments will total 100% of last year’s total tax.

A reader writes in, asking:

“What is the relationship between the new ‘pass-thru’ income deduction for ‘qualified business income’ and the contribution limits for self-employed retirement plans such as a Solo 401-K?”

Firstly, the new deduction does not have any effect on how much you can contribute to a solo 401(k) — or to a SEP or SIMPLE.

Contributions to such accounts do, however, affect the amount of your qualified business income (QBI) deduction. That is, the deduction you get from pre-tax contributions to such accounts reduces your qualified business income, which reduce your deduction for such income.

Why Do Pre-tax Contributions Reduce Qualified Business Income?

Given that deductions for a self-employed person’s own contributions to a SEP IRA, SIMPLE IRA, or solo 401(k) do not appear on Schedule C (i.e., they do not reduce self-employment income) it surprises many people that such contributions are considered to reduce qualified business income. Nonetheless, they do.

According to the instructions to Form 1040, qualified business income is reduced by “other deductions attributable to the trade or business including, but not limited to, deductible tax on self-employment income, self-employed health insurance, and contributions to qualified retirement plans.”

The Regulations on the topic say essentially the same thing: “In general, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section
199A and §1.199A-3 are otherwise satisfied. Thus, for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.”

Those two references only mention contributions to qualified plans (i.e., 401(k) plans, rather than SEP/SIMPLE IRA accounts) explicitly, but it’s clear that the same line of reasoning would apply to SEP IRA or SIMPLE IRA contributions. (Also, for what it’s worth, TurboTax clearly takes that position in its tax calculations.)

Financial Planning Implications

Essentially, your marginal tax rate for qualified business income is lower than it would be without the deduction (because each additional dollar of income causes you to get $0.20 of deduction, subject to phaseouts). In other words, pre-tax SEP/SIMPLE/solo 401(k) contributions aren’t as valuable as they would be without accounting for the QBI deduction.

As a result, Roth contributions would now make sense in some cases where tax-deferred contributions would have made sense before.

Also, if your household is doing some tax-deferred contributions and some Roth contributions, it will be advantageous to make sure that, to the extent possible, your tax-deferred contributions are to accounts that will not reduce your qualified business income. For example if you are self-employed and your spouse has a “regular” job as an employee, it would be preferable for your spouse to make tax-deferred 401(k) contributions while you make Roth solo 401(k) contributions rather than vice versa or doing 50/50 each.

Example: You’re in the 22% tax bracket. A $10,000 pre-tax contribution to your spouse’s 401(k) saves you $2,200 (ignoring state/local income taxes for simplicity’s sake). Conversely, a $10,000 pre-tax contribution to your solo 401(k) only saves you $1,760. That is, at first glance it saves you $2,200, but it also reduces your QBI by $10,000 and therefore reduces the size of your QBI deduction by $2,000 (i.e., 20% of $10,000), which causes an additional $440 of income tax (i.e., 22% of $2,000).

If your business is a specified service business and your taxable income is in the phaseout range, the key message is the same: your marginal tax rate for your qualified business income will be something other than simply your tax bracket. So it will be important to actually do the math before making any related decisions.