Freelancers generally have to deal with managing withholdings all by themselves — which can mean a nasty surprise come tax season.
Freelance work comes with advantages, like choosing your own hours and being your own boss, but it also has its own set of unique challenges. Think back to the knights of old who would offer their service and loyalty to other lords, if the price was right. They would then spend the next few months sending invoices to those lords, hoping to get paid for the fighting they actually did.
Just like those knights of old (who we entirely made up for purposes of this article, by the way), today’s freelancers will often face difficulties when it comes to receiving payment for the work they’ve done. But freelancers today also face a challenge the knights of old probably didn’t have — dealing with the complications of tax filing.
Yes, freelancers and side hustle experts may feel like they have a higher tax rate. A 2019 survey by Upwork and Freelancers Union found that three-quarters of freelancers were somewhat-to-very concerned about tax rates.
CPA Logan Allec, owner of the personal finance website Money Done Right, warns that freelancers are often surprised by the tax bill on their freelance income. This can happen because some freelancers pay their entire annual tax bill at one time when filing taxes. Contrast this to salaried employees, where the IRS mandates the withholding of a certain amount of taxes from each paycheck.
“While every freelancer welcomes the extra cash in their pocket, they may not be so ecstatic about filing their tax return come April 15,” Allec says — or in the case of 2020 for the 2019 tax year, come July 15, which is the tax extension deadline due to the economic fallout from the coronavirus pandemic.
Freelancing also comes with an additional “self-employment tax.” Standard employers pay a portion of the Social Security tax and Medicare tax for each of their full-time employees. If you are self-employed, you are required to pay each of those taxes in their entirety, which can lead to a surprisingly high bill.
Finally, while this is not a tax expense, having to cover your own health insurance in full in addition to office supplies and other essentials means there will be less money when the tax bill arrives.
However, there are some ways to make your freelance business less of a burden on your personal finances.
No. 1: Pay as you go
If there’s one piece of advice nearly all of our experts suggest, it’s for freelancers or independent contractors to avoid paying their taxes all in one go. As Allec explains above, freelancers often don’t have taxes withheld from their paycheck, which means they have a much bigger bill at tax time. That’s why the experts suggest paying quarterly taxes to help break up the expenses.
CPA Scott Vance says following the IRS directions to file quarterly taxes are not difficult to follow.”If you get a tax expert to help, especially if it is not tax season, the little bit of fees and aggravation up front will save you a multiple of those if you wait until tax season.”
Technically, the IRS requires quarterly payments from freelancers who make at least $400 in income after expenses, so following this advice is less of a “neat trick” and rather, abiding by a rule you may not have realized exists.
As a long-time freelancer/self-employed copywriter, Caryn Starr-Gates says tax bills should not be an issue if self-employed taxpayers are filing their state and federal taxes on a quarterly basis.
“Sometimes you owe more, sometimes you get a refund—but you usually avert nasty surprises because you’ve already been paying in,” she says. “Be sure to set aside a set amount every month as your invoices are paid — either flat amount or percentage, whichever works — in a separate savings account earmarked for tax payments.”
No. 2: Consider an S-corp
You’ve probably read headlines about all the methods big corporations use to reduce their taxable income. Wouldn’t it be nice to get access to just a little bit of that corporate magic to reduce your own tax liability? Candace Stevens, founder of Number Cruncher, LLC, says that having the right entity set up is important to help you save on tax liability. “If a freelancer’s earnings are high enough, usually over $50,000 a year, it is a good idea to look into incorporating. S-corporations are a pass-through entity where the profit is only subject to income tax.”
S-corporations are small businesses. In the instance of an incorporated freelancer or contractor, an S-corporation is so small, it only has one employee.
As the owner and sole employee of a corporation, you can avoid paying a portion of the self-employment tax mentioned above. While you will need to pay yourself a salary that is subject to these taxes, you can choose a smaller salary and take the rest of the corporation’s profits as a corporate distribution. This will allow a smaller portion of the money you make as a freelancer to be subject to the “self-employment tax.”
There are fees associated with incorporating, however. Certain states will also require additional corporate taxes. Consult a financial professional about your specific situation and the laws of your state to find out if incorporating will actually save you money and how to follow the rules responsibly.
No. 3: Identify deductions
As Vance mentioned earlier, spending some money on a tax professional could save you more in the long run. That is because, in addition to choices like incorporation, there are tax deductions you may not know about in addition to the more commonly known ones, like general business expenses.
Starr-Gates suggests asking a tax advisor about whether to maintain a home office and which expenses you should track throughout the year to maximize possible deductions. If you’re an incorporated small business, it’s all the more advisable to consult a professional so you can find out what might be tax deductible beyond those home office deductions. If you can’t afford a tax professional, you can look into tax software like Quickbooks or TurboTax.
No. 4: Evade tax evasion
Mistakes are more likely to happen when you’ve got an irregular tax situation. But fear not! Even if you screw up or can’t afford your tax bill, you can still avoid the Al Capone treatment.
“If you do get caught and owe significant taxes, don’t hide,” cautions Vance. “The IRS is easy to work with as long as you are upfront.” If you do not pay your taxes, you could face fines, and if you are found to be deliberately hiding your taxable income, you could face prison time.
No. 5: Don’t fret
Paying taxes as a freelancer is never going to be a good time. But don’t fret — hopefully these tips will make it a little less painful.
Logan Allec is a CPA and owner of the personal finance website Money Done Right. After spending his twenties grinding it out in the corporate world and paying off more than $35,000 in student loans, he dropped everything, and in 2017, launched Money Done Right. His mission is to help everybody — from college students to retirees — make, save, and invest more money. He resides in the Los Angeles area with his wife Caroline. Follow him on Twitter @moneydoneright.
Caryn Starr-Gates is a professional copywriter whose career dates back to the days of the typewriter. She works in advertising, marketing, and public relations for a broad range of clients across many industries. She has worked on regional and national campaigns for consumer package goods, retail, hospitality, travel, financial services, education, professional services, and more. She launched StarrGates Business Communications in 2009. Follow her @StellarCopy
Candace (Candy) Stevens is a tax preparer/accountant who works tirelessly to help her clients have the lowest tax liability legally possible and help them become financially successful. Before starting Number Cruncher, LLC, Candy owned and operated many different businesses where she was responsible for the bookkeeping and accounting. Candy now crunches numbers and advises a wide variety of clients on the ever-changing tax laws and strategies. Follow her @LlcNumber.
Scott Vance is an enrolled agent serving the greater Raleigh, NC area. He began his career in tax and accounting soon after retiring from the Army. Scott’s military background allows him to closely understand the issues faced by our military personnel, but he works with clients from all walks of life.
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