Earned income is generally recorded in two ways for federal tax purposes. There is W-2 income and 1099-MISC income. The former is for employees, either full- or part-time; the latter is for contract workers, sometimes known as a freelancers. Here’s what you need to know to minimize your tax liability if you file a 1099-MISC. If you’re unsure about filing taxes, engage the services of a financial advisor.
Contract work is by far the most common form of self-employment. It allows workers to strike out on their own without necessarily having to launch a formal business. However, taxes for freelancers aren’t fun. For a W-2 employee, the employer and the employee each pays half of the individual’s payroll taxes. This comes to about 7.65% for the employer and the employee each. However, a 1099-MISC employee must pay both halves of this tax, amounting to a flat-tax increase of 7.65% across the board for the self-employed. This is known, appropriately enough, as the self-employment tax.
Since taxes tend to start out pretty high for contractors they try hard to cut that bill. If this is how you earn a living or just some money on the side, here are some tips.
Deduct Your Business Costs
This is the big one.
As a contractor you are, for tax purposes, running a one-person business. This means that you can deduct any and all legitimate business expenses from your taxable earnings. Like any other tax deduction, you calculate your expenses and reduce your total taxable income by that amount. For example, if you earned $75,000 in freelance income during the year and spent $20,000 on relevant expenses, you’ll only owe taxes on $55,000.
Don’t forget to track your startup costs, which the IRS deems intangible assets and which must be amortized over several years. Be sure to note the exact date that the process began and then divide expenses between the costs to get an office up and running (utilities, creating a website, advertising and renting an office space) and the cost of incorporation or otherwise being legally organized in your state and locality. This includes attorney’s fees.
Business costs allow you to itemize tax deductions even if you take the standard deduction. (They are filed on a separate form.) As a contractor, they can also apply to a wide scope of expenses and activities. For example, you can often deduct office supplies, computer equipment or even travel and dining expenses depending on the nature of your work.
When you split costs between work and personal use you must divide your deduction appropriately. For example, if you buy a new laptop, you need to estimate how much time you spend on it for work and how much for personal use, then deduct the cost of the device accordingly.
That reduction notwithstanding, go over your budget for the year with a fine-tooth comb. Expenses to consider include:
- Do you have a website?
- Did you buy business cards or any other advertising materials?
- Did you spend money on office equipment, such as a computer or a phone?
- Did you spend money on office supplies, such as pens, paper and other essentials?
- Do you have an office or even a desk area? (You can deduct the costs related to any square footage in your home dedicated exclusively to work.)
- Did you spend money on productivity software and apps?
- Did you buy books or relevant periodicals?
- Do you have any subscriptions relevant to your industry?
- Did you “network,” that is, entertain anyone who works in your field, such as getting dinner or drinks with them?
- Did you travel for work? If you used your own car, what were the mileage, tolls and gas costs?
- Did you pay for membership in professional associations or for licenses?
- Did you pay for professional training or certification?
- Do you have any facilities or equipment that you use and paid for?
- Did you pay for any utilities or other recurring bills specifically for work-related matters?
In general, did you do anything that relates to how you earn a living? Given how often contractors and freelancers pursue their passions, there’s often a lot more overlap than you might think between how you’ve lived your life and what relates to your work.
Keep your receipts, because expenses listed on them are deductible.
The General Services Administration and State Department have set per diems for federal workers traveling both within the United States and abroad. This is known as the M&IE rate, and it covers the costs of meals and incidentals. If you travel for work, you may use these per diems as the basis for your deductions rather than attempting to calculate your own expenses. This can be particularly useful for contractors whose work takes them to places that don’t tend to give receipts, and it helps ensure that the IRS won’t push back on your deductions.
Failed Business Costs
One thing that many freelancers and contractors don’t realize is that you don’t need a project to succeed in order to deduct its costs. You can deduct any business expenses that have to do with your field of work. It doesn’t matter whether that particular venture succeeded.
Take a trip that didn’t lead to any successful work? Buy a bunch of supplies for a project that went nowhere? It’s okay. As long as the expenses were legitimate, you can deduct them.
Most contract workers are what’s called a “sole proprietorship.” This means that they don’t work under any formal tax structure. All of their earnings become personal income, which they report and then pay taxes on.
The common alternative is to incorporate into an S Corporation. These are private corporations generally intended for a single individual or a small number of people (no more than 100 individuals). Your earnings would be reported as earnings for the S Corporation, which would then pay you a salary (generally all earnings, less business expenses). This changes your tax status, particularly as relates to the self-employment tax. Read more at the IRS website to see if this might be a good move for you.
Self-Employment Tax Deduction
Your tax forms will guide you to this, but it’s still important not to miss.
If you file taxes with a 1099, you must pay that additional 7.65% in taxes. This comes to a total of 15.3% in payroll taxes. Of that total payroll tax, the IRS allows you to deduct between 50% and 57% from your taxable income.
This is a significant deduction. Definitely don’t miss out on it.
Insurance Premiums and Retirement Accounts
If you have forms of professional or liability insurance that are relevant to your job, you may be able to claim those as business expenses.
Meanwhile, contractors who pay for their own health and dental insurance can claim these costs directly as a deduction. This also applies to any insurance costs you pay for your immediate family.
Finally, don’t forget to deduct your contributions to any qualifying retirement accounts, like a SEP-IRA. Since you don’t have someone managing a 401(k) for you there’s no one to do this for you, and it’s certainly important to take care of.
The Bottom Line
All contractors want to cut taxes. The best way to do this is to pay careful attention to your business expenses, but there are plenty of other places where you can save some money, too. These include failed business costs, incorporation expenses, self-employment deductions, insurance premiums and contributions to retirement accounts.
- Consider working with a financial advisor as you work on your taxes. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- The federal income tax system is progressive, so the rate of taxation increases as income increases. Use this free income tax calculator to get quickly get a good estimate of what you owe Uncle Sam.
- Make sure you pay your quarterly taxes. Four times per year, anyone who earns a significant amount of 1099-based income is required to file taxes based on what they would owe from that quarter’s earnings. Failure to do so comes with a modest penalty. Much more importantly, not filing your quarterly taxes is a good way to get a massive tax bill come April.
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