The U.S. tax code is notorious for being difficult to navigate. For self-employed individuals, things are especially complicated. We've compiled some important information on the best deductions, benefits, and tips that could help ensure you submit an accurate and ultimately beneficial tax return.
What is self-employment tax?
When you began working for yourself, you took on a lot of the responsibilities that a traditional employer would handle for you. One area where this is particularly evident is the taxes that support government-issued benefits like Social Security and Medicare. Since every working adult in the U.S. chips in for both of those services, any money you earn as a self-employed entrepreneur is subject to taxation.
Self-employed tax rates
If you were working for an employer, approximately 8% of your gross income would cover both Social Security and Medicare taxes, with your employer providing a matching contribution. Once you become self-employed, whether you own your own business or are working as an independent contractor, you will be responsible for the full tax, including the half your employer would have covered. According to the IRS, the current self-employment (SE) tax accounts for 15.3% of a person's gross income and consists of 12.4% for Social Security tax and 2.9% for Medicare tax.
Remember that your SE tax is separate from your federal income tax, which you will also need to calculate and pay to the IRS.
How do you calculate your self-employment tax?
When coming up with your self-employment tax, note that the IRS limits how much can be taxed for either Social Security or Medicare and applies that to your net earnings. According to the IRS, only the first $137,700 in 2020 earnings will be taxed for Social Security. If you're a single filer and your earnings go over $200,000 (or $250,000 if you're a joint filer), then 0.9% of additional Medicare tax will be applied to those earnings.
So, in order to calculate your self-employment tax, you will have to take your net earnings for the year and calculate how much of that income is subject to the tax. You would owe 15.3% of that amount toward your SE tax. For example, a self-employed person earning $100,000 in a year would owe $15,300 toward Social Security and Medicare.
How and when to file taxes
When you will file your taxes depends on whether you will be filing on an annual or quarterly basis, since you should consider taxes throughout the year. This decision depends on a number of factors, including how much you'll be withholding, if you receive untaxed income, and if you're self-employed or an independent contractor. Depending on your answers to those questions, you may need to pay quarterly instead of every year.
As for how you file your taxes, you could hire a CPA to manage the process for you or do it yourself. If you go it alone, we recommend using one of our best picks for online tax software, since these options are quick and accurate. By making sure you handle your taxes in a professional manner, you can avoid falling behind on taxes and needing a tax debt relief service to get you out of trouble with the IRS.
12 tax deductions, benefits and tips for the self-employed
As you prepare your self-employment taxes, you should know about the deductions and benefits that can improve the process for you while lowering your tax bill. By knowing what's available to you as a self-employed taxpayer, you can put together the most accurate and beneficial filing possible for the 2020 tax year.
1. Self-employment tax deduction
When you calculate your SE taxes, you'll be figuring out how much you have to contribute to both Social Security and Medicare. Again, this is because you are assuming the contribution responsibilities that an employer would have handled for you in addition to your own tax requirements.
However, you can deduct the employer portion of your self-employment taxes from your adjusted gross income. According to the IRS, this deduction only applies to your federal income tax and "does not affect either your net earnings from self-employment or your self-employment tax."
2. Retirement plan contributions
Just because you're not working for a traditional employer doesn't mean you have to deny yourself a retirement plan. Contributing to a SEP IRA, SIMPLE IRA, Roth IRA, or traditional 401(k) could lower your overall tax bill while helping you plan for the future.
Under the IRS' current tax plan, a self-employed individual can defer up to $19,500 to all of their retirement plans, "including pre-tax and Roth contributions." You can make additional contributions depending on your self-employment earnings, the maximum amount being $57,000. Limits vary by plan type and change each year, though, so double-check the maximum before you commit to those contributions.
3. Mileage deduction
If your vehicle is an important aspect of your business, you can deduct the miles you put on it in a tax year. Though the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated some of the deductions associated with mileage, the IRS maintains a table of standard mileage rates that shows how much you can deduct for certain vehicle usages.
For strictly business purposes, you can deduct each mile at 57.5 cents, while charity mileage and miles driven for medical or moving needs can be deducted at 14 cents and 17 cents per mile, respectively. Those figures show a continuing downward trend, with the 2021 tax season only allowing business miles to be deducted at a rate of 56 cents per mile and moving and medical expenses eligible for a deduction of 16 cents per mile.
4. Meals and travel deductions
If your business requires you to travel to meet clients or go out for meals with them, you should definitely keep track of those expenses, because you can deduct them from your taxes. As long as these meetings are strictly for business, up to 50% of the meal's cost can be deducted with proper documentation. You can find the standard meal allowance for your business on the U.S. General Services Administration website.
Like most parts of the tax code, the TCJA further changed how meal and entertainment costs are deducted. According to the IRS, "if food or beverages are provided during or at an entertainment event, and the food and beverages were purchased separately from the entertainment or the cost of the food and beverages was stated separately from the cost of the entertainment on one or more bills, invoices, or receipts, you may be able to deduct the separately stated costs as a meal expense."
Under the TCJA, if the meal and entertainment are not listed separately on your receipt, neither can be used as a deduction.
5. Qualified business income deduction
Up to 20% of your qualified business income can be deducted from your taxes, provided you meet several criteria set by the IRS. According to the federal government, your income for 2020 must be less than $163,300 if you're a single filer or $326,600 if you're filing jointly. If you go over those limits, the IRS then determines if you're still eligible for a full or partial deduction.
Under the current IRS guidelines, the qualified business income is "the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business," excluding things like capital gains and losses, dividends, interest income, foreign income, and some payments to partners and shareholders.
6. Business loan interest deduction
If you had to take out a business loan to cover expenses, the associated interest could be deducted from your taxes. While that's great news for you, if you used the loan for any personal expenses in addition to your business ones, you'll only calculate the business ones for deductions. The same goes for credit card deductions. To get this deduction, you'll have to keep meticulous records of how you used the money.
7. Net operating loss (NOL) carryback
Even if you don't operate under a traditional business structure, you can still use your net operating losses to lower your tax obligation. A net operating loss, or NOL, happens when a business's deductions are more than its taxable income. These NOLs can be carried over to future tax years to lower tax liabilities. Before the passage of the TCJA, these carryovers were limited to 20 years. That restriction has been removed, but NOLs are now capped at 80% of the taxable income of any given period.
Further changes for NOLs took place after the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020. Those changes make all the difference, said Jackie Meyer, CPA, president and founder of Meyer Tax Consulting.
"The CARES Act made changes to NOLs that provided a five-year carryback for losses earned in 2018, 2019, or 2020, which allows firms to modify tax returns up to five years prior to offset taxable income from those tax years," she said.
Under the CARES Act, the NOL carryback rules also pertain to individuals, estates and trusts, and tax-exempt organizations, so if you've had a particularly rough go of it, you can potentially use the NOL to offset your taxes.
8. Home office deductions
Many more people have had to familiarize themselves with this cost in 2020 thanks to the COVID-19 shutdowns. Any costs you incurred to keep your home workspace running during the tax year can be deducted as a home office expense.
Along with office space costs, you can deduct a percentage of your home's mortgage interest, your home's depreciation, homeowners insurance, utilities, and repairs. How much of those costs can be deducted depends on how much of the home your workspace occupies. The larger the office space in your home, the greater your tax deductions.
9. Rent costs
Similar to the home office cost deductions, you can deduct the rent you pay for an office space, as well as the rental fees for any additional equipment you needed during the tax year. You can also deduct business lease cancellation fees, though you can't deduct rent expenses if you won the property.
10. Self-employed health insurance
Everybody gets sick, so you likely have your own health insurance. If you aren't on your spouse's plan and you pay for your own premiums, you can deduct your entire health, dental, and some qualified long-term care premiums. If you have dependents listed on your health insurance plan, such as a spouse and children younger than 27, you can deduct those costs as well. The IRS provides a worksheet to calculate the amount of your deduction.