How Much to Set Aside for Taxes as an Independent Contractor

When you transition from a W-2 employee to a 1099 independent contractor, the biggest shock is usually the tax bill. Because your clients don't withhold taxes from your paychecks, you are entirely responsible for paying the IRS directly. If you don't save a portion of every payment you receive, April will be a very stressful month.

So, exactly how much should you set aside? The short answer is 25% to 30% of your net income. But to understand why, and to get an exact number for your situation, you need to understand the three different taxes you owe as a freelancer.

The Three Taxes Every 1099 Worker Pays

1. Self-Employment Tax (15.3%)

This is the tax that catches most new freelancers off guard. When you are a W-2 employee, you pay 7.65% of your income toward Social Security and Medicare, and your employer pays the other 7.65%. When you are self-employed, you are both the employer and the employee, so you must pay the full 15.3% yourself. This applies to your net profit (income minus business expenses).

2. Federal Income Tax (10% to 37%)

On top of the self-employment tax, you still owe standard federal income tax based on your tax bracket. For most middle-income freelancers, this adds another 12% to 22% to your tax burden.

3. State Income Tax (0% to 13.3%)

Depending on where you live, you will also owe state income taxes. If you live in Texas, Florida, or Nevada, your state tax is 0%. If you live in California or New York, it's 0%. But if you live in Oregon, Hawaii, or Minnesota, it can add 8% to 10% to your total tax bill.

The "Rule of Thumb" Percentages

Because everyone's tax situation is different, there is no single percentage that works for everyone. However, financial professionals generally recommend these safe harbor saving rates based on your total annual income:

• Earning under $50,000/year: Set aside 20% to 25% of every payment.
• Earning $50,000 to $100,000/year: Set aside 25% to 30% of every payment.
• Earning over $100,000/year: Set aside 30% to 35% of every payment.

Don't Forget Quarterly Estimated Payments

The IRS does not want to wait until April to get your money. If you expect to owe $1,000 or more in taxes for the year, the IRS requires you to make quarterly estimated tax payments. These are due four times a year: April 15, June 15, September 15, and January 15.

If you fail to make these payments, or if you underpay them, the IRS will charge you an underpayment penalty and interest when you file your annual return.

How to Calculate Your Exact Number

Rules of thumb are great for general saving, but when it's time to actually write a check to the IRS, you need an exact number. Guessing too high means you're starving your business of cash flow; guessing too low means penalties.