I originally posted this on my blog a little under two years ago. If it's interesting to you, I post new content on daedtech.com roughly weekly.

Alright, time for a reader question Monday post.  I’m sure nothing takes the edge off of the end of your weekend like me answering reader questions.  So, let’s do that.

I've talked before about taxes for people going fully independent and hanging our their shingles.  But this one is all about taxes for side hustlers.

Here’s a composite of the reader question, since several folks, some from different professions, have asked me about this.

How should I handle taxes when I have a full time job and I start moonlighting?

In all likelihood, this will be a fairly US-specific post.  But there are commonalities with other tax systems, as I’ve learned by having an increasingly global set of colleagues and folks that I talk to.

So, hopefully, even those of you not in the US can get some value out of this.

Wait, Why Is This an Issue at All?

I’m going to really start from first principles here, in this discussion of taxes.  In other words, I’ll assume that you not only didn’t know how to handle taxes from income when you moonlight, but that you didn’t know you needed to do anything to handle them.

Alright, so here’s the thing.  Let’s say, for the sake of easy math, that you earn $52,000 per year, paid biweekly.  This results in paychecks of exactly $2,000.

At least, that’s what it will say under the “gross income” portion of your paystub.  As you well know, Uncle Sam has his fingers deep into your pockets before the direct deposit ever hits.

For the sake of more easy math, let’s say that your overall tax rate is 25%, meaning that you take home $1,500 per paycheck.  (This is extremely facile, since the US has a graduated income tax system.)

So every paycheck, the government (actually, your employer, but forget that for a moment) hangs onto $500 and you bring home $1,500.  At the end of the year, when you do Turbo Tax or drag your receipts to H&R Block, you neither owe money nor receive any.

Why?

Well, because, in a rather unusual circumstance, your employer has withheld exactly what you owe.

But what if you now start earning $1,000 per month moonlighting?  When you moonlight, nobody withholds income.

So now, at the end of the year, you have something of a problem.  Your total earnings are now $66,000 (52K + 12 months of 1K), but you’ve only paid $13,000 of the $16,500 that you owe throughout the year.  You're going to need to pay the IRS $3,500 at tax time.

Oh, and they're going to penalize you.  But let's worry about that part later.

The Mechanics of Withholding

So, what should you do?  I'll get to that.  It's complicated, and you have a few options.  But first, let's talk about how income tax withholding actually works for those of you out there in salary land.

When you start a new job, your employer will ask you to fill out something called a W-4.  Remember how a moment ago, I comically said, let's assume the IRS just takes 25% of your income?

Well, it's a little more complicated than that.  And, by a little, I mean an unfathomably enormous amount.  It depends on how many kids you have, what color your toaster is, and how many easements you've farmed in flood plain zones among other things.

The IRS has a really, really complicated formula for figuring out tax burden.  It's so compmlicated that the W-4 form is designed to provide a rough approximation of what you're going to owe, and to err on the conservative side.

So you fill this form out, and it gives you an employer a figure that, when withheld from your paycheck, should result in a modest tax refund in April.

Once this happens, you start to receive checks from the company.  The company pays you $1,500, and the company sets aside the other $500 (plus a bit more besides) that it pays to the IRS: your taxes and their so-called payroll taxes.  And this is the reason you never really have to worry about the IRS except for each April when they buy you a lawnmower or a trip to Key West.

The Unbounded Avarice of the IRS

Alright, so you get how withholding works now.  And you understand the problem of extra income that no one has subject to withholding.  We can now talk about the penalty that I mentioned earlier, so that you understand the full scope of what you're trying to avoid.

To do that, I'm going to have a little fun and exaggerate a little, but not terribly.  And that's where the avarice of the IRS comes in.

Remember our toy scenario where $500 of tax per paycheck was the "perfect" withholding?  This is perfect in the sense that you don't owe the IRS money nor do they owe you money.  But it's not perfect for the IRS.

For the IRS, a perfect scenario is that your employer withholds $2,000 of your $2,000 paycheck, giving you none.

Then, at the end of the year, the IRS send you a refund of $39,000.  This is perfect for them, because the IRS's principal goal in dealing with you is to put your money in the bank and earn interest on as much of it as possible.

From their perspective, your wages are theirs, not yours, to earn interest on.  When they give you a refund, that might be a nice influx of cash, but it's been sitting in their (for argument's sake) bank account earning interest all year -- not yours.

Why am I telling you this?

So you'll remember what the IRS wants vis a vis your paycheck.  If you set aside too much money, you're good.  If you set aside the "perfect" amount, you're good.

You can even owe the IRS a little money at the end of the year.  But owe them more than a little, and they get cranky.  Your money is theirs -- not yours.

The Underpayment Problem

Don't believe me?  Here's some fun reading on "topic 306, underpayment of estimated tax."  It gives you insight into both the ownership of your money and the murkiness of all things taxes.

Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.

This is already confusing to the lay person, and they throw a "generally" in front of it.  So this translates as "if you owe less than $1,000 at years' end or if you paid 90% of your tax or 100% of last year's tax, you're most likely fine. Most. Likely. Mwahahahaha."

So if you slip up and underpay, you might have two problems:

1. You have to write the IRS a check for the balance of tax that you owe.
2. You might have to write them an additional check for "penalties."

An Interlude In (Sorta) Defense of the IRS

I've been ragging pretty heavily on the IRS up to this point, and I stand by that.  The US tax system is all the way broken and getting worse.

But I will offer some words to talk you down from the ledge before I get into specific strategy recommendations.  When it comes to dealing with taxpayers not in the Monopoly Guy's tax bracket, the IRS is actually kinda decent.  For instance.

• I've had to pay underpayment penalties before, and I think they were like $6.  It's not a big deal if you're not deliberately sand-bagging.
• If you deal with humans at the IRS, they're generally pretty reasonable.
• I once filed a return where I made a mistake and understated my refund.  The IRS corrected it and sent me my due.
• I once made an estimated payment a month late and the IRS didn't care or charge me.

Why do I mention all of this?

To get you to relax a little.  The IRS and taxes seem really intimidating if you're not used to dealing with them.  But take deep breaths, because even if you mess up in good faith, it probably won't be a big deal.

Okay, so what do you do with your extra income?  How do you avoid penalties and problems?  I'll give you a few strategies.

First up, the absolute most bulletproof strategy.  This is sort of a hassle and probably overkill, but if you do this, you will absolutely not have any problems.

Blue Chip Strategy: Make Estimated Payments

As a wage employee, your tax burden is pretty predictable.  You earn the same thing (COLAs/increases notwithstanding) every year.

So you can figure out your maximum tax burden without deductions.  Recall that I mentioned the US has a graduated tax system with tax brackets.

So, while it's not as simple as a percent, you can figure it out with a little work at the calculator.  For instance, let's look at the 2018 tax brackets and our hypothetical $52,000/year earner (who is single).

• He pays a 10% tax on income up to $9,525 for a total of $952.50.
• Then, he pays 22% on income from $9,525 to $38,700, for a total of $6418.50.  This makes the running total $7,371.
• And, finally, he pays 24% on income from $38,700 to his total $52,000, for a tax total of $3,192.  This makes his entire tax burden $10,563.

Now, in reality, he will owe less than this.  There's something called the "standard deduction" and incentives to marry, have kids, be energy efficient, buy houses, etc.

But his upper bound federal tax liability is $10,563, and we're doing the blue-chip, worst case scenario, remember?

So what about this extra $12,000 of moonlighting income?  Well, when you look at the tax brackets, you can calculate the tax rate on that marginal income.

For a single earner in 2018, the 24% bracket goes up to $82,500, so all of that additional income will fall in the 24% tax rate.  So what you do is simple.

You set aside 24% of all of your moonlighting income into, say, a savings account.  And then, once per quarter, you empty that account and send an estimated payment to the IRS.  (And, by quarterly, they actually mean in April, June, August, and January).

It's worth mentioning that you need to do the same thing at the state level, with state income taxes, but that's simpler, so I'm focusing on the feds.

Viable Strategy: Decrease Your Withholdings

That strategy, properly executed, cannot fail.  But it's also a hassle.

Quarterly estimated payments and a new savings account?  Ugh.

You have another arrow in your quiver, if you want.  You can tell your employer to increase your withholding.

A lot of people think that W-4 form is some kind of official, sacrosanct IRS document.  But it isn't.  It's just a heuristic.

You can go to your employer and ask them to increase your "allowances" on the form, which will have the effect of fattening your paychecks.  (What this really means is that you're telling the IRS that you have a lot of deductions that you'll claim, so your employer should withhold less money.)

Or, in the case of a moonlighter, you can go the opposite direction.  You can decrease your allowances, or you can just flat out tell them to withhold more money.  This makes your paychecks smaller and the IRS happier.

So you can approach this particular strategy in one of two ways.  You can attempt to project and calculate your moonlighting income and tax burden and then increase withholding to match.

Or, you can just bump it an allowance or two and hope for the best.  (That may sound iffy, but I've done this before and it's been fine.)

The withholding strategy is a little murkier, but it has the advantage of you not learning new, painful ways of dealing with the IRS.

Iffy Strategy: Devil May Care

The last strategy that I'll offer is one for people that are only going to have a bit of moonlighting income, or who don't know when that income will start or stop.  You can just see what happens.

This isn't as crazy as it sounds.  For instance, imagine that instead of a $1,000 a month game-changer, our freelancer earned $500 the first month and nothing after that.

That would make his marginal tax burden $120, so he'd owe $120 at the end of the year instead of owing nothing.

¯_(ツ)_/¯

The IRS won't care about that, and, as long as you've got the money in your bank account, neither should you.

You can just kinda play it by ear.  If your income starts to pile up, file it in the "good problems to have" department, and jack your withholding way up at the end of the year.

As long as you're increasing your withholding in the same quarter as you have extra income, the IRS doesn't care.  And, even if you overcompensate a quarter or two later, the penalties are pretty negligible, especially for someone making $52,000.

So you really can just wing it.  And, if makes you feel any better, "wing it" was my moonlighting strategy for years.  If it caused me problems, I don't recall them.

You'll Be Fine

I'm going to close with a little game theory here, to put things in perspective.  It's easy for this stuff to feel overwhelming, particularly if you're risk averse and fiscally conservative (I'm both).

But don't let that stop you from a side hustle.

This isn't just a "fortune favors the bold" thing.  I want you to think about the IRS for a moment.

Think about what it probably costs to send an expert out to do an audit.  Let's say it's 2-3 days of time for a pro that's worth $100 per hour.  That's $1,600 to $2,400, and I feel like I'm putting a conservative estimate on the scope of an audit (at least, an in person one), since I'm not including travel or expenses.

This means that, for an audit to be worthwhile, you have to be under-reporting by thousands of dollars.  The $52K earner's marginal tax burden in our story?  $288.

It's literally not worth the IRS's time to chase after this.  Until your moonlighting business blossoms to the point where you have 7 figures of revenue, they really don't care about you.

Could you be selected for a random audit?  Sure, anything is possible.  But if you're making a good faith effort to do the right thing, earning a few bucks on the side, and fumbling your way through, you're going to be fine.

Good luck with the taxes, and happy side-hustling.

If you'd like to ask a reader question, you can do so at the "ask me" page.