Uncle Sam must be paid, and if you want to prevent an audit, it’s crucial to do it correctly the first time. Self-employed people do not have taxes taken from their paychecks automatically as W-2 workers do. They are responsible for keeping track of their debts and making timely payments.
Take-home income for self-employed people is often larger than for wage employees since taxes aren’t automatically withheld from their paychecks. However, it’s a good idea to put aside some of those earnings to pay your taxes if you don’t want the IRS to show up at your door.
According to Shoshana Deutschkron, vice president of communications and marketing at Upwork, “company owners, whether they are self-employed freelancers or corporation owners, are responsible for complying with tax legislation with regard to their business.” Financial literacy is a crucial ability, and part of that literacy is knowing how taxes work.
Lise Greene-Lewis, a CPA and tax specialist for TurboTax, adding, “You need to hang onto part of your money.” Because of how often your income fluctuates, “you should act as if you don’t have very much money. You should consider paying your taxes.
Not only are government documents intimidating, but understanding taxes can be quite difficult. Here are the fundamentals of reporting, paying, and saving for taxes if you’re filing with the IRS as a self-employed person.
Self-employed tax obligations
Deutschkron advised self-employed people, including freelancers, to track their business expenses so they can claim them as tax deductions at the end of the year. They also need to consider their tax burden when planning their annual finances (such as saving money vs. reinvesting it in the business).
The following categories are used by the IRS to classify self-employed people:
- The practice of becoming a lone entrepreneur or independent contractor in a trade or company
- Being a partner in a partnership that runs a company or commerce
- Otherwise running your own business (including a part-time business)
Pew Research estimates that 15 million Americans work for themselves. When you work for yourself, you must pay both income tax and self-employment tax.
What is self-employment tax?
Social Security and Medicare taxes are shared between the employee and the employer when they work for an organization. Your employer matches the little portion of your gross income that you contribute toward these taxes, which is just under 8%.
The whole 15.3% tax is your responsibility if you don’t have an employer. These taxes are divided as follows: Medicare receives 2.9% of the budget while Social Security receives 12.4%. (It’s important to note that only the first $137,700 of income produced annually—a figure that is subject to change each year—is subject to the Social Security tax. Any salaries in excess of that are exempt. An inversion exists for Medicare. There is no ceiling on the 3.8% tax rate applied to salaries above $200,000 per year.
The basics for filing self-employment taxes
Before you can calculate your tax liabilities, you must first know your tax rate and if your location has distinct municipal taxes. To determine your rate, first determine your business’s net profit or loss. You may figure this out by deducting your company expenditures from your revenue. If your costs are lower than your revenue, the remaining amount, known as your net profit, becomes a portion of your income. Your net loss will be the difference if your costs outweigh your revenue.
You must first comprehend your tax rate as well as any state and local taxes that could be applicable to you before you can prepare to submit your taxes. Determine your net profit or loss for the taxable period before calculating your tax rate.
Next, a Schedule C must be filed if your self-employment income exceeds $400. (Form 1040). Though you fulfil any of the additional criteria specified in Form 1040, even if your net self-employment earnings were less than $400, you must still submit a return.
The IRS states that self-employed people who anticipate owing more than $1,000 in self-employment tax are required to submit anticipated tax payments four times a year. These quarterly taxes must be filed using IRS Form 1040.
Using free tools like this one from TaxAct, you may estimate the self-employment tax you anticipate paying.
How to calculate your self-employment tax
The 12.4% Social Security tax and the 2.9% Medicare tax are both included in the self-employment tax rate for 2019 of 15.3%. Your net earnings are subject to self-employment tax. Your self-employment income may be subject to an extra 0.9% Medicare tax if it exceeds $200,000 for single filers or $250,000 for joint filers in 2019. For 2019, only the first $132,900 of your earnings are due to Social Security tax (this level rises to $137,700 in 2020).
As was previously said, in order to compute your self-employment tax correctly, you must determine your net self-employment earnings for the year, which are equal to your self-employment gross revenue less your company costs. The typical self-employment tax rate is 92.35% of your net self-employment income. Use the tax rate of 15.3% to calculate your overall self-employment tax after calculating your entire net earnings from self-employment that are subject to tax.
There are two possible ways to determine net profits on the IRS Schedule SE whether your self-employment had a loss or only produced a little amount of revenue for the year.
Self-employment tax FAQs
Do you pay self-employment tax on passive income?
The quick response is no. Your passive income isn’t subject to the self-employment tax if the IRS defines it as such (although it will likely be subject to income tax). According to the IRS, passive income comes in two forms. The first is a trade or business in which you don’t engage regularly throughout the year. Passive income is earned when you fully or substantially control a company that runs independently of you. If you’re not a real estate expert, the second category is rental activity. You may take part in these activities actively without being subject to the self-employment tax.
What kinds of jobs are exempt from paying the self-employment tax?
Any position that earns less $400 annually is excluded. Regardless of the kind of labour done, it is true. Clergy who work for a congregation are a significant exception. They are not subject to self-employment tax on any of their income. That exemption could not apply if a clergy person is compensated by a religious organization rather than the congregation.
Do self-employed people pay higher taxes?
Self-employed individuals do, on average, pay more in taxes. The self-employment tax has resulted in a higher tax rate on paper. For anybody thinking about working for yourself, it is a crucial factor to take into account. Nevertheless, there are several situations in which self-employed individuals may end up paying lesser effective taxes.
The majority of the time, this is true for company owners. You may take advantage of tax deductions and incentives if you operate your own firm. When properly leveraged, the extra tax advantages may offset the higher self-employment tax and result in a lower overall effective tax rate.
How to file your taxes
Use Form 1040-ES, Anticipated Tax for Individuals, which includes a worksheet comparable to Form 1040, if you anticipate making quarterly estimated tax payments. Keep your tax return since you’ll need it to complete Form 1040-ES.
You may send your estimated tax payments using the blank vouchers that come with Form 1040-ES, or you can pay online using the Electronic Federal Tax Payment System (EFTPS). If this is your first year working for yourself, you’ll need to make an educated guess as to how much money you’ll bring in. For additional details, see the IRS’s website on estimated taxes.
You must disclose your revenue (or loss) from any businesses you owned or sole-proprietorship practises you engaged in in order to complete your yearly return. Schedule SE (Form 1040), Self-Employment Tax, is required to be filed in order to report your Social Security and Medicare taxes.
Ways to save on taxes
It’s crucial to identify write-offs if you’re leaving a full-time job. Here are six methods for deducting taxes:
You may write off your starting expenses from your tax bill if you just launched a new firm. These include things like marketing expenses and legal expenditures.
Along with the mileage deduction for travel expenditures, you may also deduct up to $25,000 in car expenses.
Home office deduction:
If you have a location designated only for work-related activities, you may deduct your home office. To accomplish this, calculate the square footage of your home office to find out how much you may write off for utilities, property taxes, rent or mortgage payments, and so on.
Supplies and equipment:
You may write off from your taxes any equipment or office supplies required for the performance of your work.
Social Security and Medicare taxes:
Self-employed persons are subject to the entire Social Security and Medicare levy, just like other employers. At the end of the year, they may write off half of it.
Health insurance premiums:
You may be able to deduct healthcare expenses for you and your family from your taxes if you are a self-employed person.
Greene-Lewis stated, “You could be surprised by what is tax-deductible.”Advertising is a good example. It helps people generate money, but it also costs them a lot of money.”
Tax software may simplify the filing process, help you find write-offs you would have missed otherwise, and make it easier to calculate your tax rate. Additionally, it preserves your tax information, which you may transfer to the subsequent tax year if no significant changes occur.To compute the amount of Social Security and Medicare taxes you should have paid during the year, use the income or loss estimated on Schedule C or Schedule C-EZ. Filling out the form could benefit from reading the instructions for Schedule SE.
Tax deductions and tax credits
Tax deductions and tax credits may come to mind first when searching for strategies to reduce your tax burden. But are you aware of the distinctions between the two? H&R Block asserts that although tax deductions reduce the total amount of your taxable income, tax credits directly reduce the amount of taxes you owe.
Deductions reduce your taxable income, which lowers your tax burden through reducing your tax bracket rather than by lowering your actual taxes. Standard deductions and itemized deductions both exist.
The standard tax deduction is available to almost everyone; the amount is dependent on your filing status (e.g., single, married filing jointly, married filing separately, or head of household), but it is the same for everyone with the same status.
There are numerous different itemised deductions that may be taken, and each person’s deduction amounts are unique. Some of the most popular itemised deductions include the following:
- Certain medical and dental expenses above 7.5% of your adjusted gross income
- State income taxes
- State sales and local tax
- Property taxes
- Charitable contributions
- Mortgage interest
- Student loan interest
However, there is a caveat for itemised deductions. Each taxpayer may not claim both of their itemised and basic deductions, just the one that is greater.
There are two categories of tax credits: refundable and non-refundable:
- Nonrefundable tax credits let you completely eliminate your tax burden.
- Your tax reliability might potentially drop to zero due to refundable tax credits. You’ll also get the remainder of your refundable credit, if any money is left over from it.
Here is an illustration of how a tax credit and a tax deduction differ: A $1,000 deduction results in a $250 tax reduction if you are in the 25% tax bracket. But a $1,000 credit reduces your tax obligation by $1,000.
What is superior? You would probably opt to get a tax credit if given the choice. These potential tax credits are listed below:
- Earned income credit
- Additional child tax credit
- American opportunity credit
- Credit for federal tax on fuels
- Premium tax credit
- Health coverage tax credit
Being prepared come tax season
Keeping track of your costs all year long is essential if you want to be ready for your tax responsibilities. Greene-Lewis advised against leaving the calculation of your costs until the last minute. She suggested utilizing accounting software to keep tabs on your income and expenses.
According to Business News Daily, QuickBooks is the greatest accounting programme for small companies as a whole, whereas Zoho Books is the top programme for microbusinesses (sole proprietors, freelancers, consultants, etc.). See our top selections for further recommendations and software evaluations.