When one pays Quarterly Estimated Self Employment Taxes, exactly what are they paying?

Question

Ok, I have read more articles than I can count, and I'm still unclear on my expectations regarding taxes for this year.

I am newly self-employed (as of July 15th) and soon I will need to make my first estimated quarterly tax payment. To assist in this process, I've started to use the self-employed version of QuickBooks online. I've entered all of my personal details and projections, including former W-2 wages and taxes for Jan 1 through June 30th and the numbers that I'm being given as tax estimates. to me, seem rather low compared to former tax payments as a W-2 employee in previous years.

I've been in contact with QuickBooks support. They've been fast and mostly helpful but they tend to direct to US Government tax based articles and calculators found on IRS.gov. Maybe I'm over-reading this stuff, but usually that only leads me to more questions and further confusion.

Most of the calculations that I'm running seem to say that this low tax estimate is correct but I can't see how this can be true. When I total up all my expected taxes for this year, and what I'm expected to pay, the number is much smaller than what I made in 2015, and 2016 should actually be a better paying year than last year. Shouldn't my tax bill, therefore, be higher?

I found this one article on IRS.gov, Self-Employment Tax (Social Security and Medicare Taxes).

Specifically, the article states:

It should be noted that anytime self-employment tax is mentioned, it only refers to Social Security and Medicare taxes and does not include any other taxes that self-employed individuals may be required to file.

Ok, so by that one line, it is my understanding that when I pay these quarterly estimates, I'm strictly paying estimates on Social Security and Medicare. Does this mean that when 2017 arrives and I have to fill out my tax forms for personal income I'll have to calculate and pay 100% of all respective income tax on April 15th that are not related to Social Security and Medicare!?

However, the following article is more indicative of everything I've found on the internet: Self Employment Federal Income Taxes.

This article doesn't say that estimated taxes include estimates for Federal Income Tax, nor does it imply that quarterly estimates only include Social Security and Medicare. Furthermore, I can't find a single article, anywhere, that explicitly states that self-employed individuals will pay their income tax 100% at end-of-the-year tax time.

My question is this; when I pay Quarterly Tax Estimates what, exactly, am I paying? Furthermore, should I always expect a tax bill come April 15th because that's how self employment taxes work when you're self employed?

Thanks to anyone who has been through this. I just don't want to be shocked with a HUGE, unexpected bill next year.

Answer 1

From the IRS page on Estimated Taxes (emphasis added):

Taxes must be paid as you earn or receive income during the year, either through withholding or estimated tax payments. If the amount of income tax withheld from your salary or pension is not enough, or if you receive income such as interest, dividends, alimony, self-employment income, capital gains, prizes and awards, you may have to make estimated tax payments. If you are in business for yourself, you generally need to make estimated tax payments. Estimated tax is used to pay not only income tax, but other taxes such as self-employment tax and alternative minimum tax.

I think that is crystal clear that you're paying income tax as well as self-employment tax.

To expand a bit, you seem to be confusing self-employment tax and estimated tax, which are not only two different things, but two different kinds of things. One is a tax, and the other is just a means of paying your taxes.

"Self-employment tax" refers to the Social Security and Medicare taxes that you must pay on your self-employment income. This is an actual tax that you owe. If you receive a W-2, half of it is "invisibly" paid by your employer, and half of it is paid by you in the form of visible deductions on your pay stub. If you're self-employed, you have to pay all of it explicitly.

"Estimated tax" does not refer to any actual tax levied on anyone. A more pedantically correct phrasing would be "estimated tax payment". Estimated taxes are just payments that you make to the IRS to pay tax you expect to owe. Whether you have to make such payments depends on how much tax you owe and whether you've paid it by other means. You may need to pay estimated tax even if you're not self-employed, although this would be unusual. (It could happen, for instance, if you realized large capital gains over the year.) You also may be self-employed but not need to pay estimated tax (if, for instance, you also have a W-2 job and you reduce your withholding allowances to have extra tax withheld).

That said, if you earn significant income from self-employment, you'll likely have to make estimated tax payments. These are prepayments of the income tax and Social Security/Medicare taxes you accrue based on your self-employment income.

As Pete B. mentioned in his answer, a possible reason that your estiamtes are low is because some taxes have already been withheld from the paychecks you received so far during the year (while you were an employee). These represent tax payments you've already made; you don't need to pay that money a second time, but you may need to make estimated tax payments for your income going forward.

Answer 2

Your question does not say this explicitly, but I assume that you were once a W-2 employee. Each paycheck a certain amount was withheld from your check to pay income, social security, and medicare taxes. Just because you did not receive that amount of money earned does not mean it was immediately sent to the IRS. While I am not all that savvy on payroll procedures, I recall an article that indicated some companies only send in withheld taxes every quarter, much like you are doing now. They get a short term interest free loan. For example taxes withheld by a w-2 employee in the later months of the year may not be provided to the IRS until 15 January of the next year.

You are correct in assuming that if you make 100K as a W-2 you will probably pay less in taxes than someone who is 100K self employed with 5K in expenses. However there are many factors. Provided you properly fill out a 1040ES, and pay the correct amount of quarterly payments, you will almost never owe taxes. In fact my experience has been the forms will probably allow you to receive a refund. Tax laws can change and one thing the form did not include last year was the .9% Medicare surcharge for high income earners catching some by surprise.

As far as what you pay into is indicative of the games the politicians play. It all just goes into a big old bucket of money, and more is spent by congress than what is in the bucket. The notion of a "social security lockbox" is pure politics/fantasy as well as the notion of medicare and social security taxes. The latter were created to make the actual income tax rate more palatable.

I'd recommend getting your taxes done as early as possible come 1 January 2017. While you may not have all the needed info, you could firm up an estimate by 15 Jan and modify the amount for your last estimated payment. Complete the taxes when all stuff comes in and even if you owe an amount you have time to save for anything additional. Keep in mind, between 1 Jan 17 and 15 Apr 17 you will earn and presumably save money to use towards taxes. You can always "rob" from that money to pay any owed tax for 2016 and make it up later.

All that is to say you will be golden because you are showing concern and planning. When you hear horror stories of IRS dealings it is most often that people spent the money that should have been sent to the IRS.