En español | Thanks to the COVID-19 pandemic and the recession, more than 6 million additional people are working part time in the gig economy. Many of these adults who are involuntarily self-employed are working for lower wages than they had at their previous jobs and getting fewer benefits, too. The tax breaks for the self-employed can help soothe some of that pain — but taxes can also sting you if you're not prepared. Here's how to manage your taxes if you're suddenly self-employed.
Know which deductions you can claim
A big break for the self-employed
Under the 2017 Tax Cuts and Jobs Act, self-employed individuals can deduct 20 percent of their qualified business income (QBI) from their federal income taxes. If you generated $45,000 in income from your business and had $10,000 in deductions, your QBI would be $35,000. You can then deduct 20 percent of that, or $7,000, from your income, which will reduce the amount of tax you owe.
You don't have to form a special type of business to get the self-employment deduction. If you're a sole proprietorship — as many self-employed people are — you're entitled to the tax break. Other fine print:
- The break reduces only federal income tax, not the self-employment tax.
- The deduction is phased out for joint filers with $315,000 to $415,000 in personal income, and between $157,500 to $207,500 for all other filing statuses. You get no deduction if your personal income is above those ranges.
- The deduction is limited for individuals in some traditionally high-paying service businesses, such as lawyers and doctors.
"It's a phenomenal deduction, and most businesses qualify,” says McNeill. “You may be able to generate income this year and pay almost no income tax on it at all."
If you're self-employed, you can claim a federal income tax deduction for your ordinary and necessary business expenses. “Ordinary” in this case means common and accepted costs in your line of business. “Necessary” means something that is helpful for your business. (It doesn't have to be indispensable to be deductible.) A deduction lowers your income, which, in turn, reduces your taxes. You report your business income and expenses on Schedule C, Profit or Loss From Business, on Form 1040.
One advantage for the self-employed: Most business deductions aren't subject to the same limitations as personal deductions. For tax year 2020, for example, your personal medical deductions have to be more than 7.5 percent of your adjusted gross income in order to deduct them. But self-employed individuals may be able to deduct some medical expenses, such as the cost of their health and dental insurance, from their business income. If you have a disability, you can deduct any medical expenses necessary for you to work, instead of claiming them as personal medical deductions.
The other advantage is that in some businesses, the deductions for being self-employed can be quite large. For example, drivers for Uber and Lyft (as well as other similar companies) can deduct the cost of gasoline, regular car maintenance, registration fees, auto and health insurance, and even the cost of car washes. Similarly, if you make things, such as cakes, you can deduct the cost of the goods required to create your products: in this case, flour, sugar, cake boxes, baking utensils and cleaning supplies.
Other deductions may seem small, but they can add up over the year. If you accept credit cards, for example, you can deduct the fees that credit card companies charge your business. And you can also deduct fees for licensing your business. For a full rundown on what you can and can't deduct, see Internal Revenue Service (IRS) Publication 535, Business Expenses.
Keep track of your expenses
You will have to document these expenses, which means keeping receipts. Start saving and compiling receipts as soon as you can. “I always say to people, ‘I can't remember what kind of sandwich we had for lunch yesterday, so you know you can't expect to remember what you did in February, or even three months ago,” says Mackey McNeill, a certified public accountant in Bellevue, Kentucky.
If you're using your own property to create a service — such as driving your car for Uber — you'll also have to keep records of how much time you use your car for the job, and how much you drive it for personal use. If you have an inexpensive car and drive lots of miles, you can use the standard mileage rate — 57.5 cents per business mile, McNeill says. If you have an expensive car and don't drive many miles for your business, then the actual costs may give you a bigger deduction, she says. In either case, you have to keep close track of your expenses. QuickBooks, a popular accounting software program, will track mileage for you, as will Xero and FreshBooks, McNeill says.
And don't overlook the home office deduction. There's a simplified home office deduction: $5 per square foot, up to 300 square feet, or $1,500 per year. “That can be a nice deduction,” McNeill says. But remember that if you report having a dedicated space for your home office, you'll have to prove that space is used for nothing but work if the IRS comes to check.
Don't overlook deductions for your phone, if you use that for business, and your computer, too.
Save for Social Security and Medicare taxes
One challenging part about self-employment is you're responsible for all of your Social Security and Medicare taxes. “That's probably the biggest surprise for people who are self-employed for the first time,” says Nathan Rigney, lead tax research analyst at the Tax Institute at H&R Block.
When you are an employee, your employer pays half the required federal taxes for Social Security and Medicare. When you're self-employed, you're on the hook for the whole amount: 12.4 percent for Social Security and 2.9 percent for Medicare. “There's no real way of softening that blow,” Rigney says.
Social Security taxes apply to the first $132,900 of your income in 2019 and the first $137,700 for 2020. The Medicare tax applies to all your income.
Many people who are involuntarily self-employed have also, at some point, collected unemployment. Those benefits are taxable. You can have taxes withheld from unemployment benefits, but many people choose not to, Rigney says. “They need the cash flow at the time, so they don't have taxes withheld.” The result can be a bigger tax bill than they may have expected.
You need to estimate the Social Security and Medicare taxes as accurately as possible to avoid penalties for withholding too little. You can avoid the penalty if you owe less than $1,000 in tax after subtracting your quarterly tax payments and any tax credits, or if you paid at least 90 percent of the tax due for the current year, or 100 percent of the tax shown on the return for the prior year, whichever is smaller. You use Form 1040-ES, Estimated Tax for Individuals, to make estimated tax payments.
McNeill recommends putting aside 25 percent of all the income you get into a savings account just for taxes. Use the funds in the account to pay your required estimated taxes, which will usually be less than what you save. At the end of the year, once your tax return is prepared, you'll know exactly how much you owe. “If you have extra, you'll be very happy,” says McNeill. You can use those dollars for an IRA [individual retirement account], or just for fun. More importantly, you won't start the next tax year with a big tax bill, or a payment plan from the IRS. Without proper saving it is easy to go from “What an exciting new venture to ‘Wow, how am I going to get out of debt?'” McNeill says.