As a freelancer or a self-employed individual, your take-home pay may be significantly more than if you were working for a corporation. Not only are taxes not taken out, but also you don't have a company directly deducting health care, 401k or other financial costs from your paycheck.
This can lead to a temptation to spend it all, but self-employed professionals shouldn't be fooled into thinking they actually have the full amount of their check.
"Business owners, whether they are self-employed freelancers or corporation owners, are responsible for complying with tax law with respect to their business," said Shoshana Deutschkron, VP of communications at freelance job platform Upwork. "Financial literacy is a critical skill, [and] that literacy includes an understanding of taxation."
"You need to hold onto some of your money," added Lisa Greene-Lewis, CPA and TurboTax tax expert. "You should pretend you don't have that much money, because your income varies so often. You have to think about paying your taxes."
If you're filing as "self-employed" with the IRS, here are the basics of filing, paying and saving for taxes. [See Related Story: Want to Be a Full-Time Freelancer? What You Need to Know]
Self-employment tax obligations
Freelancers must take their taxes into account when setting their pricing, consider tax burden in planning their finances for the year (e.g., saving money vs. re-investing it in the business), and track their business expenses to deduct them at the end of the year, Deutschkron said.
According to the IRS, self-employed individuals are classified as:
- Carrying on a trade or business as a sole proprietor or an independent contractor.
- Being the member of a partnership that carries on a trade or business.
- Being otherwise in business for yourself (including a part-time business)
When you're self-employed, you must pay a self-employment tax (SE tax) as well as an income tax. The SE tax is a Social Security and Medicare tax that is primarily for individuals who work for themselves. This is separate from income tax.
Before you can determine your tax obligations, you must figure out your net profit or net loss from your business. You can calculate this by subtracting business expenses from your business income. If your expenses are less than your income, the difference is net profit and becomes part of your income. However, if your expenses are more than your income, the difference is a net loss.
You have to file a Schedule C (Form 1040) income tax return if your net earnings from self-employment were $400 or more. Even if your net earnings from self-employment were less than $400, you still have to file a return if you meet any other requirements listed in the 1040 form. You should also file if you are eligible for any of the following credits:
- Earned-income credit.
- Additional child tax credit.
- American opportunity credit.
- Credit for federal tax on fuels.
- Premium tax credit.
- Health coverage tax credit.
According to the IRS, self-employed taxpayers who expect to owe more than $1,000 in SE taxes must make estimated tax payments four times per year. You will need to use IRS Form 1040 to file these quarterly taxes.
You can estimate your expected SE tax using free calculator tools like this one offered by Quickbooks.
How to file your taxes
If you expect to make quarterly estimated tax payments, use the Form 1040-ES, Estimated Tax for Individuals, which contains a worksheet that is similar to Form 1040. Be sure to keep track of your return from one year to the next, as you will need your prior year's annual tax return to fill out Form 1040-ES.
The IRS allows you to fill out Form 1040-ES, which contains blank vouchers you can use when you mail your estimated tax payments, or you may make your payments using the Electronic Federal Tax Payment System (EFTPS). If this is your first year of being self-employed, you will need to estimate the amount of income you expect to earn for the year. See the IRS's Estimated Taxes page for more information.
To file your annual tax return, you will need to report your income or loss from a business you operated or a profession you practiced as a sole proprietor. To report your Social Security and Medicare taxes, you must file Schedule SE (Form 1040), Self-Employment Tax.
Use the income or loss calculated on Schedule C or Schedule C-EZ to calculate the amount of Social Security and Medicare taxes you should have paid during the year. The instructions for Schedule SE may be helpful in filing out the form.
Ways to save on taxes
If you're transitioning from a full-time position, here are six tax-saving tips that may assist you as a first-time self-employed taxpayer, according to TurboTax:
- Startup costs: Newly formed businesses may be able to deduct startup costs, including legal fees, cost of experimentation and advertisements.
- Vehicle expenses: In addition to the mileage deduction and other expenses, self-employed taxpayers may be able to deduct up to $25,000 of the cost of their car or SUV.
- Home office deduction: Self-employed workers who have a dedicated space in their home that they used only for business can deduct a percentage of their home expenses, including mortgage payments, utilities and property taxes.
- Supplies and equipment: Office supplies, from paper to computers — even snacks for customers — may be deductible if they were used exclusively for business.
- Social Security and Medicare taxes: Self-employed workers must pay the entire 15.3 percent Social Security and Medicare tax, but get a break by writing off half of what they pay.
- Health insurance premiums: Self-employed workers may be able to deduct what they pay for medical insurance for themselves and their family.
"You may be surprised about what is tax-deductible," Greene-Lewis said. "For example, advertising helps people make money, but it's also a big deduction for people."
Other expenses to consider
As a self-employed professional, you won't have access to any corporate-backed benefits. While you're not required by law to have things like a retirement plan, for instance, other benefits, like health insurance, are absolutely imperative. Under the Affordable Care Act (ACA), you must purchase a health care plan before the beginning of the next tax season to avoid tax penalties.
Without coverage, you could owe 2.5 percent of your household income, or a maximum of the total yearly premium for the national-average price of a Bronze plan under the ACA. This could mean a penalty of $695 per adult, or a maximum of $2,085. For more information on benefits for the self-employed, visit this Business News Daily guide.
The key to being prepared for your tax obligations is to keep track of your expenses all year round. Don't wait until the last minute to add up all of your expenses, Greene-Lewis said. She advised using an accounting software package to help you track of what you're earning and spending.
Business News Daily recommends Quickbooks as the best accounting software for small businesses overall, and Zoho Books as the best accounting software for micro businesses (i.e., sole proprietors, freelancers, consultants, etc.). For more suggestions and software reviews, visit our best-picks list.
Before you file, ensure the accuracy of your tax forms by checking them with an accounting professional.