SELF EMPLOYED? Everything You Need To Know About Taxes

In contrast to W-2 employees, self-employed individuals are responsible for handling their own taxes. Taxes are not automatically deducted from their paychecks, and it's their responsibility to keep track of what they owe and ensure timely payments. The absence of automatic tax deductions means that the take-home pay for self-employed individuals is typically higher compared to traditional wage earners. However, to avoid any unwelcome visits from the IRS, it's advisable to set aside a portion of those earnings to cover your tax obligations. Dealing with taxes can be intimidating, and the complexities of taxation can be particularly daunting. If you're filing as self-employed with the IRS, it's crucial to understand the basics of filing, making payments, and saving for your tax responsibilities.

 

NO.1: WHAT DOES IRS CONSIDER SELF-EMPLOYED?

 

Self-employed individuals, including freelancers, need to be mindful of their tax obligations at various stages of their business endeavors. This includes:

1. Setting Pricing: When determining the prices for their products or services, self-employed individuals should factor in their tax liabilities to ensure they can meet these obligations while sustaining their business.

2. Financial Planning: It's essential to consider their tax burden when planning their finances for the year. This decision-making process involves deciding whether to save money for taxes or reinvest it back into the business.

3. Expense Tracking: Tracking business expenses is crucial as it enables deductions at the end of the year, which can significantly reduce the tax liability.

Shoshana Deutschkron, former VP of communications and brand at Upwork, emphasizes that all business owners, regardless of their status as self-employed freelancers or corporation owners, bear the responsibility of complying with tax laws concerning their business. Being financially literate includes having an understanding of taxation and its implications.The IRS classifies self-employed individuals into several categories, including sole proprietors, independent contractors, partnership members, and those otherwise engaged in their own business activities. Self-employed individuals are required to pay both self-employment tax and income tax.
Lise Greene-Lewis, a CPA and tax expert for TurboTax, underscores the importance of prudent financial management. Self-employed individuals should operate under the assumption that they don't have as much money as it appears due to the variable nature of their income. Being prepared for tax obligations is a vital aspect of sustaining a successful self-employed career.

 

NO.2: WHAT IS SELF EMPLOYED TAX?

 

When you're employed by a business, the burden of Social Security and Medicare taxes is shared between you and your employer. You contribute a bit less than 8 percent of your gross income toward these taxes, and your employer matches that contribution. However, if you're self-employed and don't have an employer, you are solely responsible for the full 15.3 percent tax. This tax is divided as follows: 12.4 percent is allocated to Social Security, and 2.9 percent goes to Medicare. It's important to note that only the first $160,200 of income earned in a year (this amount may change annually) is subject to the Social Security tax. Any earnings exceeding this threshold are exempt from this particular tax.

 

NO.3: THE BASICS FOR FILLING SELF-EMPLOYEMENT TAXES

 

To determine your tax obligations as a self-employed individual, it's essential to be aware of your tax rate and whether your local jurisdiction requires separate city taxes. Here's a breakdown of the steps to follow:

1. Calculate Your Net Profit or Net Loss: Begin by calculating your net profit or net loss from your business. You can do this by subtracting your business expenses from your business income. If your expenses are lower than your income, the difference represents your net profit, which is considered part of your income. If your expenses exceed your income, the difference reflects your net loss.

2. Understand Your Tax Rate: To prepare for filing your taxes, you must first comprehend your tax rate, and be aware of any state and local taxes that may apply to your business. Your tax rate is determined by your net profit or loss during the taxable period.

3. Filing Requirements: If your self-employment earnings surpass $400, you are required to file a Schedule C (Form 1040). Even if your net earnings from self-employment are less than $400, you still need to file a return if you meet any of the other criteria outlined in Form 1040.

4. Estimated Tax Payments: According to the IRS, self-employed taxpayers who anticipate owing more than $1,000 in self-employment tax must make estimated tax payments on a quarterly basis throughout the year. You will need to utilize IRS Form 1040 to submit these quarterly tax payments.

By following these steps, you can accurately determine your tax obligations as a self-employed individual, ensuring that you comply with tax regulations and avoid potential penalties or issues with tax authorities.

 

NO.4: HOW TO CALCULATE YOUR SELF-EMPLOYED TAX?

 

For the tax year 2023, the self-employment tax rate is 15.3 percent, which comprises the 12.4 percent Social Security tax and the 2.9 percent Medicare tax. This self-employment tax applies to your net earnings. It's worth noting that, in 2023, only the first $160,200 of your earnings is subject to the Social Security tax.
As mentioned earlier, to accurately determine your self-employment tax liability, you must calculate your net self-employment earnings for the year. This involves subtracting your business expenses from your self-employment gross income. Generally, 92.35 percent of your self-employment net earnings are considered taxable for self-employment tax purposes. Once you have the total net earnings from self-employment that are subject to tax, apply the 15.3 percent tax rate to calculate your overall self-employment tax liability.
In situations where you've experienced a loss or have minimal income from self-employment during the year, the IRS offers two optional methods to calculate net earnings, as outlined in the IRS Schedule SE. These methods can be valuable when your self-employment income fluctuates or when you're dealing with a limited amount of self-employment income.

 

NO.5: HOW TO FILL YOUR TAXES

 

1. QUARTERLY PAYMENTS

 

If you anticipate making quarterly estimated tax payments, you should utilize Form 1040-ES, known as Estimated Tax for Individuals. This form includes a worksheet that is similar to the one found on Form 1040. It's important to retain a copy of your prior year's tax return, as you will require this information to complete Form 1040-ES accurately.

You have the option to use the blank payment vouchers that come with Form 1040-ES to mail your estimated tax payments to the IRS. Alternatively, you can opt to make these payments online via the Electronic Federal Tax Payment System (EFTPS), a convenient electronic payment method.

If this is your first year of being self-employed, you will need to estimate the amount of income you expect to earn during the year for the purpose of making these estimated tax payments. For additional details and guidance on estimated taxes, you can visit the IRS' Estimated Taxes page, which provides comprehensive information on how to fulfill your tax obligations as a self-employed individual.

 

2. ANNUAL RETURN

 

When you're ready to file your annual tax return as a self-employed individual, you must report the income (or loss) generated from your business or profession operated as a sole proprietor. To accurately report and settle your Social Security and Medicare taxes, you are required to file Schedule SE (Form 1040), which is specifically designated for Self-Employment Tax purposes.

To calculate the amount of Social Security and Medicare taxes you owe, you should use the income or loss figures derived from your Schedule C or Schedule C-EZ. These schedules are used to determine your taxable income or loss from your self-employment activities. The instructions provided for Schedule SE can be a valuable resource in helping you complete the form accurately.

By following these steps and diligently reporting your income and associated taxes, you can fulfill your tax obligations as a self-employed individual and remain in compliance with IRS regulations.

 

NO.6: TAX DEDUCTIONS & TAX CREDITS

 

1.TAX DEDUCTIONS

 

Deductions are a vital aspect of the tax system, as they reduce your taxable income, ultimately lowering the amount of taxes you owe by placing you in a lower tax bracket. There are two main categories of deductions: standard deductions and itemized deductions.

Standard Deductions:
- Most individuals qualify for the standard tax deduction, and the amount varies based on your filing status (e.g., single, married filing jointly, married filing separately, or head of household). Each filing status has a predefined standard deduction amount. 

Itemized Deductions:
Itemized deductions are specific expenses that you can deduct from your taxable income, and the deduction amounts vary by individual. Common itemized deductions include:
Certain medical and dental expenses exceeding 7.5 percent of your adjusted gross income.
   State income taxes.
   State sales and local taxes.
   Property taxes.
   Charitable contributions.
   Mortgage interest.
   Student loan interest.

It's important to note that you can choose either the standard deduction or itemized deductions, but not both. You should select the one that provides a higher deduction.

For those transitioning from a full-time position to self-employment, there are several potential write-offs to consider, including:

1. Startup Costs: Deduct startup expenses like legal fees and marketing costs for your new business.

2. Vehicle Expenses: Deduct vehicle expenses, including a mileage deduction for travel.

3. Home Office Deduction: If you maintain a dedicated home office, you can deduct a portion of your rent or mortgage payments, utilities, and property taxes based on the square footage of your office space.

4. Supplies and Equipment: Deduct expenses for office supplies and equipment necessary for your work.

5. Social Security and Medicare Taxes: Self-employed individuals pay the full Social Security and Medicare tax but can deduct half of it at the end of the year.

6. Health Insurance Premiums: Self-employed individuals may be eligible to deduct healthcare costs for themselves and their families.

As Lisa Greene-Lewis points out, there are often unexpected deductions available, such as advertising expenses. Tax software can be a valuable tool in identifying these write-offs, streamlining the filing process, and ensuring accurate tax calculations. It also simplifies the transfer of prior year's tax information to the new tax year if your financial situation remains relatively consistent.

 

2. TAX CREDITS

 

Tax credits are a valuable tool for reducing your overall tax liability. There are two main types of tax credits: nonrefundable and refundable.

Nonrefundable Tax Credits:
Nonrefundable tax credits can reduce your tax liability to zero. However, if the credit amount exceeds your tax liability, you won't receive the excess as a refund. It effectively eliminates your tax obligation but doesn't provide a refund beyond that point.

Refundable Tax Credits:
Refundable tax credits not only reduce your tax liability to zero but, if there's any remaining credit balance, you'll receive the excess as a refund. In essence, these credits can result in a refund check back to you if they exceed your total tax liability.

To illustrate the distinction between tax credits and tax deductions, consider the following example: If you're in the 25 percent tax bracket, a $1,000 tax deduction would lower your taxes by $250. In contrast, a $1,000 tax credit would directly reduce your tax bill by the full $1,000. The advantage of tax credits is that they provide a dollar-for-dollar reduction in your tax liability.

If you had to choose between the two, tax credits are generally more advantageous, as they directly reduce the amount of tax you owe and can even lead to a tax refund if they exceed your total tax liability.

Here is a list of some common tax credits:
Earned Income Credit
Additional Child Tax Credit
American Opportunity Credit
Credit for Federal Tax on Fuels
Premium Tax Credit
Health Coverage Tax Credit

These credits can help lower your tax bill or potentially result in a tax refund, depending on your individual circumstances and eligibility.

 

NO.7: BEING PAREPARED COME TAX SEASON

 

Being well-prepared for your tax obligations as a self-employed individual involves maintaining a year-round record of your expenses. It's not advisable to leave this task until the last minute. Instead, consider implementing ongoing expense tracking. Lisa Greene-Lewis suggests using an accounting software package to streamline the process of monitoring your earnings and expenditures. 

In terms of accounting software recommendations for small businesses and microbusinesses (e.g., sole proprietors, freelancers, consultants), here are a couple of options:

1. QuickBooks: QuickBooks is widely regarded as an excellent accounting software application for small businesses. It offers a comprehensive set of features for managing finances, including expense tracking, invoicing, and financial reporting.

2. Zoho Books: Zoho Books is recognized as a top accounting solution for microbusinesses. It is a user-friendly and cost-effective option, particularly suited for sole proprietors, freelancers, and consultants.

It's worth noting that there are numerous accounting software options available, each with its own set of features and pricing. It's advisable to explore various options, read reviews, and choose the one that best fits your business needs and budget. Ongoing expense tracking with the right accounting software can greatly simplify tax preparation and help ensure you're well-prepared when tax season arrives.

 

NO.8: SELF EMPLOYEMENT TAX FAQ

 

1. DO YOU PAY SELF-EMPLOYEMENT TAX ON PASSIVE INCOME?

 

No, passive income, as defined by the IRS, is not subject to self-employment tax. However, it is still typically subject to income tax. The IRS identifies two primary types of passive income:

1. Trade or Business You Don't Actively Participate In: If you own or partially own a business that operates independently from your direct involvement or management, the income generated from it is considered passive income. In this case, you do not actively participate in the day-to-day operations of the business.

2. Rental Activities (If You Are Not a Real Estate Professional): If you have rental activities, and you are not classified as a real estate professional, the income derived from these activities is also considered passive income. It's possible to actively participate in managing these rental activities without incurring self-employment tax.

While passive income may not be subject to self-employment tax, it is still subject to regular income tax. It's important to understand the distinctions between different types of income and their tax implications to ensure compliance with IRS regulations and to effectively plan your tax strategy.

 

2. DO SELF-EMPLOYED PEOPLE PAY HIGHER TAXES?

 

On average, self-employed individuals often face higher tax rates than traditional employees. The primary reason for this is the self-employment tax, which can significantly increase the on-paper tax rate. This is an important factor for anyone contemplating self-employment as it can impact their overall tax liability.

However, it's important to note that there are circumstances in which self-employed individuals can effectively reduce their tax burden. This is particularly true for business owners who have access to various tax breaks and write-offs. When these tax benefits are utilized correctly, they can help offset the higher self-employment tax, ultimately resulting in a lower total effective tax rate. 

Effectively navigating the tax landscape as a self-employed individual involves understanding the available deductions, credits, and tax strategies specific to your business or profession. Seeking professional tax advice and staying informed about tax regulations can help optimize your tax situation and potentially lower your overall tax liability.