The concept of work is gradually changing, with a growing number of people opting to work for themselves instead of joining a company’s payroll. In fact, by 2027, freelancers are predicted to make up the majority of the U.S. workforce. This means that a larger number of people will need to work out how to pay their own taxes. The self-employed tax process can be a bit more complicated, but it’s easily doable as long as you have the right resources in place.
What Are Self-Employed Taxes?
It’s important to distinguish between the taxes self-employed individuals pay and self-employment taxes themselves. Although self-employment taxes are wrapped up in the taxes you’ll pay each year, it’s only part of the greater amount you’ll owe. Self-employment taxes include your Social Security and Medicare tax, part of which would be paid by your employer if you were on a payroll. Since you’re a free agent, though, you’ll be responsible for the full amount yourself.
In addition to self-employment tax, you’re also required to pay income tax on the money you earn during the tax year. You’ll use the same tax brackets you’d use if you filed taxes based on income you made at an employer. So, if you earn $50,000 during the 2020 tax year, you’ll pay a 22 percent tax on that income, plus the self-employment tax you owe. But the good news is, as a self-employed worker, you can claim any work expenses you accrue related to doing your work.
Types of Self-Employment Taxes
Self-employment taxes are designed to take care of you during your retirement years. Your employer would normally pay part of these taxes, but since you’re self-employed, you pay the full 15.3 percent. Of that amount, 12.4 percent goes to Social Security and 2.9 percent goes to Medicare.
However, if you’re fortunate enough to earn more than $137,700 in 2020, you’ll only have Social Security tax taken out of that amount. The money you earn above $137,700 will only be subject to the 2.9 percent Medicare tax.
To figure your self-employment tax, you’ll start with Schedule SE. This is where you’ll input information on your income and determine the amount of your income subject to self-employment tax. You can also deduct the employer-equivalent portion of your self-employment tax when you’re figuring your adjusted gross income.
Underpaying Income Taxes
If you receive a paycheck from an employer, that employer will withhold taxes and submit them to the IRS throughout the year. At tax time you’re merely ensuring you paid in enough and determining whether you are owed a refund or whether you need to send a little extra because you underpaid. Unfortunately, if you’re self-employed, there’s no one to send taxes to the IRS on your behalf, which means if you earn a decent amount of money during the tax year, you’ll be shown as having underpaid, which will require you to pay penalties and interest on the taxes you were supposed to be paying to the IRS.
The IRS expects all independent contractors, including freelancers and nonsalaried business owners, to estimate the amount of taxes they’ll owe for the year and pay one-fourth of the amount at intervals throughout the year. The general rule is that if you expect to owe $1,000 or more at the end of the year, you should pay in advance, but that can be difficult to predict, especially if your income fluctuates throughout the year.
The IRS has a worksheet as part of Form 1040-ES. This will walk you through the steps of inputting your expected income to arrive at the taxes you’ll likely owe. At the end, you’ll have the amount you should pay each quarter to be compliant.
Paying Estimated Taxes
If you decide you need to pay estimated taxes, the Estimated Tax Work Sheet will give you your predicted yearly tax amount, divided by four. You’ll pay that amount April 15, June 15, Sep. 15 and Jan. 15. If the 15th falls on a weekend or holiday, the due date will be the next business day.
You can pay electronically on the IRS’s website for free, as long as you have the money taken directly from your bank account. Using a credit or debit card will incur a fee. You can also pay by personal check using the slips included with the Estimated Tax Work Sheet. Write in the amount you were instructed to pay for each quarter and make sure it’s postmarked by the due date to avoid paying penalties.
At tax time, you’ll need to input the estimated payments you made for the previous tax year on Form 1040. This will give you credit for the amount you paid in during the year. The IRS will also have this information in its system, provided you either paid electronically or put the correct Social Security number on your personal check and payment stub when you sent them in. If you’re married and file jointly, the IRS goes by the first Social Security number listed on the tax return, so make sure all quarterly payments reference that ID, even if it’s your spouse’s.
Taking Business Deductions
Since so much of your income will be taken for taxes, it’s important to claim as many deductions as you can. Where your personal deductions will need to exceed the new standard deduction of $12,400, your business deductions are separate. Perhaps the biggest of these is your health insurance deduction, which can protect a substantial portion of your income from taxation. You can claim the full amount of premiums you pay during the year on Form 1040, page one, line 9, but you’ll need to assert that you can’t access health insurance coverage through another source, such as your spouse’s employer.
If you work out of your home, you can claim your home office as a deduction, as well. Simply tally up the portion of your mortgage and utilities that is spent on that part of your home. However, the easiest way is to take the IRS option of claiming $5 per square foot, to a maximum of 300 square feet.
You can also claim the portion of your internet and cellphone that you use for business, as well as expenses like office supplies and travel costs. If you purchase a computer, you can claim that, as well, but you’ll need to follow the IRS’s guidelines on depreciation and recapture.
Taking a Loss
One negative of being self-employed is the unpredictability. One year you may make more than you’ve ever made before, followed by a year where your income plummets. In the early years, though, you may find you’re spending more to build and grow your business than you actually make.
During those early years, you can still claim your expenses, but you won’t have the income to offset them. This means you’ll be operating at a loss. Although this will give you a tax break, if you claim a loss year after year, you run the risk of having your business classified as a hobby, which now eliminates your ability to claim any expenses on your venture. You’ll still have to claim the income you earn, but you won’t get the benefits of claiming expenses.
There are varying types of self-employment, so this can vary from one person to another. If you’re building a law firm, for instance, you’re more likely to get a pass than if you were buying items for resale on eBay. One way to protect yourself is to have a business plan and operate your self-employment efforts as professionally as possible. If you can prove you’re working toward a goal to become profitable, you’ll be more likely to pass muster with the IRS.
Self-Employed at Tax Time
Being self-employed doesn’t release those who pay you from reporting the amount to the IRS. Businesses must report payments to any person they paid $600 or more during the tax year. This starts with having you fill out a Form W-9 offering your Social Security number and basic contact information.
If you work for multiple clients during the tax year, be prepared to complete forms for each of them, even if you don’t earn $600 or more from that particular client. If you hesitate to give your Social Security out freely, you can sign up for an Employer Identification Number and use that when you complete your W-9s.
It’s important to note that as a contractor, you are responsible for reporting everything you earn during the year, regardless of whether an employer pays you $600 or more. Even if you don’t complete a W-9 or receive forms at tax time, you still must report the income you made. This means you’ll need to track all of your payments and be prepared to input them.
Filing Taxes as Self-Employed
If you’re lucky enough to work for one or two clients during the tax year, tax time will be easy. The self-employed tax form you’ll receive is a Form 1099-NEC, which lists the income you received. These will come rolling in early in the year, around the time your salaried friends start receiving their Form W-2s.
You can reconcile this with the income you’ve tracked during the year and if there are discrepancies, contact the client to clear them up. But if you don’t receive a form, you’ll still need to file and be aware that the employer may have reported the income but neglected to send you a form.
Once you have your form, you’ll input the information on Schedule C, Profit or Loss from Business. Below where you enter information on the income your business made during the tax year, you can also list out the expenses, tallying up the amount for each individual category. If you use a tax preparer or software, the amount you made versus the amount of taxes you paid will help determine how much you’ll need to pay in quarterly payments for the upcoming tax year. Otherwise, you can use the Estimated Tax Work Sheet to calculate it.
Self-Employed Retirement Plans
You don’t have to be on salary to have a retirement plan. In fact, many employers today only offer options like 401(k) plans. As a self-employed professional, you can set up your own 401(k) and, as a bonus, you may even be able to protect some of your hard-earned income from being taxed.
There are multiple options, but many experts recommend an IRA or Solo 401(k). You can choose either traditional or Roth, depending on your preferences.
The traditional option means that you can put the money in pretax, which means you set part of your income aside each year. The problem is that you’ll pay tax when you withdraw it at tax time. A Roth IRA or Roth 401(k) means you put the money in after taxes now, but you’ll pay no taxes when you withdraw it at retirement.
Read more: How Much Will a Roth IRA Lower My Taxes?
- Upwork: Freelancers predicted to become the U.S. workforce majority within a decade, with nearly 50% of millennial workers already freelancing, annual “Freelancing in America” study finds
- IRS.gov: Self-Employment Tax (Social Security and Medicare Taxes)
- IRS.gov: Direct Pay With Bank Account
- IRS.gov:Form 1040
- IRS.gov: Simplified Option for Home Office Deduction
- IRS.gov: Depreciation & Recapture
- IRS.gov: Apply for an Employer Identification Number (EIN) Online
- NerdWallet: Retirement Plan Options for the Self-Employed
- IRS. "Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs." Accessed Sept 1, 2020.
- IRS. "2019 Instructions for Form 8995." Page 1. Accessed Sept 1, 2020.
- NYS Society of CPAs. "A Primer on Qualified Business Income under IRC Section 199A." Accessed Sept 1, 2020.
- IRS. "Frequently Asked Questions/Individuals 2." Accessed Sept 1, 2020.
- Social Security Administration. "Contribution and Benefit Base." Accessed Sept 1, 2020.
- IRS. "Self-Employment Tax (Social Security and Medicare Taxes)." Accessed Sept 1, 2020.
- Tax Foundation. "State Individual Income Tax Rates and Brackets for 2020." Accessed Sept 1, 2020.
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.