If you’re self-employed, you’re all on your own when it comes to taxes. That includes both paying taxes and how to figure out what to pay. Here’s everything you need to know.
If there is something you think is missing or you want to learn more about, please leave a comment at the bottom of this page.
Table of Contents
What counts as self-employed?
Self-employed includes most types of non-W2 jobs including:
- Bricks and mortar small businesses.
- Independent contractors who receive a 1099-NEC.
- Sole proprietors.
- Partners in a partnership.
- People who engage in a skilled trade on their own rather than as an employee.
- Gig economy jobs such as sports officials, rideshare drivers, and grocery deliveries.
Do I need to formally form a business?
The first thing to understand is that if you’re doing any type of self-employment work, you’re technically already a business. Depending on your type of work, there may or may not be advantages to using a more formal business structure.
What is a sole proprietorship?
If you’re earning 1099-MISC income, are selling items, or are performing services as a non-employee, you are already a sole proprietorship. Just to be clear, a sole proprietorship is a business.
Most businesses are sole proprietorships because they’re easy to form. As you can see, they’re so easy that you may not even know you formed one.
There are also a few legal questions you probably want to ask a lawyer. This is both to make sure that you’re not breaking the law and to make sure that you’re not taking unnecessary risks.
- Do I need to register with my state or local government?
- Should I register a fictitious name or DBA if I’m doing business as a name other than my given personal name?
- Do I need a permit, license, or tax receipt from the state, county, city, or other jurisdiction?
- Is there anything else I need to know from a legal standpoint?
What other business types can I use?
There are several business entity types that may apply to your situation.
Partnerships are like sole proprietorships in that you may already have one without knowing it if you’ve been working with one or more partners. The only difference is the number of people. There are also special types of partnerships, such as Limited Liability Partnerships. Finally, having a formal partnership agreement to spell out exactly how you’re going to work together and share profits and losses is always a good idea.
Corporations provide a large degree of protection for your personal assets against lawsuits, debts, and other claims against your business. You’ll need to ask a lawyer for specifics on what legal protections you’ll receive. It depends on your state and the type of business you’re doing.
- C-corporations are corporations that are taxed at a flat 21% tax rate. If you pay yourself a salary, you’ll give yourself a W-2 and pay personal income taxes on it (but the corporation can deduct the wages for its own income taxes). If you take out dividends, you’ll pay your dividend tax rate on them.
- S-corporations are a special type of corporation where corporate profits and losses pass through to your personal tax return. There is no corporate tax, but you pay your personal income tax rate on your share of earnings.
Limited liability corporations give similar liability and legal protections to corporations but have different rules and filing requirements. You may choose between having your LLC taxed as a sole proprietorship/partnership, a C-corporation, or an S-corporation.
How much do self-employed people pay in taxes?
You may face a number of taxes in addition to your normal income tax.
What is the self-employment tax?
The self-employment tax rate is commonly cited as 15.3%. This number is accurate in most cases but is really a combination of two taxes.
Social Security Tax
The Social Security tax makes up the largest portion of self-employment taxes. In 2021, the rate is 12.4% on your first $142,800 in income.
The tax rate remains consistent each year unless Congress changes it. The income cap is tied to inflation.
Above the income limit, you do not pay Social Security taxes. If you have a combination of W-2 and self-employment income that takes you above the income limit, your employer should withhold Social Security tax on all of your wages up to the income limit. You may file a claim for a refund if you have too much Social Security tax withheld.
The Medicare tax is 2.9% of all of your wages and self-employment income. Unlike Social Security, there is no income cap.
There is, however, an additional 0.9% tax on your income above the following limits:
- $125,000 if married filing separately.
- $200,000 if single or head of household.
- $250,000 if married filing jointly.
These thresholds are fixed by statute and do not automatically increase with inflation.
What other taxes do self-employed people have to pay?
You may also owe the following taxes.
State and Federal Income Taxes
You will owe personal income taxes on either your profit share or your wages plus distributions.
- For sole proprietorships, partnerships, and S-corporations, you pay your personal income tax rate on your share of the total net profits. You may be eligible for the 20% Section 199A pass-through deduction to offset some of this tax.
- For C-corporations, your tax is your personal income tax rate on your wages plus your dividends tax rate on your profit distributions.
- LLCs depend on whether you’ve elected to be taxed as a pass-through (first bullet point) or corporation.
You can calculate your potential federal tax liability using these tax calculators.
Business Income Tax
If you have a business entity other than a sole proprietorship, your state may impose a tax on your business profits. This may apply even if you reinvest the profits back into your business rather than withdrawing them.
Carefully review the rules for sales taxes for each jurisdiction where you have either a physical presence location, travel to your clients, or otherwise have sales. One key point to remember is that one area may tax services while another may not.
Business Tax Receipt/Licensing Fees
In addition to income taxes, many states, counties, and municipalities charge a flat fee for the right to do business within their borders. This fee usually ranges from $50 to $200.
The fees often apply to any business operating in their area. This may include independent contractors who work for a single company or a service professional who travels to a single client within that area.
What tax forms will you get if you’re self-employed?
There are two major tax forms you will get if you’re self employed. You get a 1099-NEC if a company pays you directly via cash, check, direct deposit, or similar means. You get a 1099-K if you get paid by credit card, PayPal, or other third-party payment processors.
What is Form 1099-NEC?
Form 1099-NEC reports non-employee compensation. That’s income earned by sole proprietors, freelancers, independent contractors, and other self-employed people.
When did Form 1099-NEC start?
Form 1099-NEC income used to be reported in Box 7 of Form 1099-MISC. There were no tax changes when the forms changed. It was simply to break off a completely more common type of income into its own form.
Form 1099-NEC was first used for the 2020 tax year. That’s for money earned during 2020 with taxes filed in April 2021. It was not for 2019 income filed in April 2020.
Why did the IRS add Form 1099-NEC?
Form 1099-NEC actually used to be a standalone form prior to 1983. That’s when non-employee compensation was moved to Form 1099-MISC.
One of the biggest problems with having non-employee compensation on Form 1099-MISC is that it meant different deadlines for Form 1099-MISC depending on what was reported on it. A Form 1099-MISC with non-employee compensation in Box 7 is due to the IRS and contractor on January 31st. Other Form 1099-MISCs are due on March 31st.
In addition to creating confusion, it also caused technical problems at the IRS trying to track whether forms were on time when payers bundled different types of Form 1099-MISC together.
Who has to issue Form 1099-NEC?
The rules for Form 1099-NEC are the same as they were for Form 1099-MISC with non-employee compensation in Box 7. It’s just a minor paperwork change.
Generally, you need to issue a Form 1099-NEC if you pay an independent contractor $600 or more during the year and the payment is not reportable on a Form 1099-K. See the instructions for exceptions.
What do you do if you get a Form 1099-NEC?
File your taxes as you would have when you received a 1099-MISC. That will generally mean completing a Schedule C.
What is Form 1099-K?
Form 1099-K was created to close a tax reporting gap that had been exploited by independent contractors and small businesses. Instead of being filed by the party paying the contractor, the form is filed by the payment processor itself. Form 1099-K is required in two circumstances.
- For any transactions using a payment card (e.g., credit card), payment card account number, or any other identifying data associated with a payment card
- For transactions completed through a third party payment network (e.g., PayPal) where the receiver has 200 or more transactions and $20,000 in payments received during the year.
Should you get a 1099-NEC and 1099-K for the same income?
Page 2 of Instructions for Form 1099-NEC says that a 1099-NEC should not be filed when payments are made via a method that’s reportable on Form 1099-K.
Some companies are still incorrectly insisting that they still need to issue a 1099-NEC. This is most often the case when their payments alone did not cross the 200 transaction and $20,000 threshold. However, the threshold is for aggregate payments not from a single payer.
How can Form 1099-K protect your identity?
One advantage of Form 1099-K is that you can avoid giving your Social Security Number to every client by using a payment processor that issues a 1099-K. This makes Form 1099-K a great way to protect your identity.
What happens if You receive a 1099-NEC and 1099-K for the same income?
In theory, nothing should happen. The income should only be reported once on Schedule C or the other appropriate form, and the taxpayer should only be taxed on the amount that was actually received.
The problem is that the IRS uses a computer system to match the forms it receives against the returns filed by taxpayers. Some independent contractors have reported that they received both forms, properly only reported the income once, and then received a CP2000 notice claiming they understated their income because they didn’t report either the 1099-NEC or 1099-K.
For example, say that the contractor received a 1099-NEC from their company and a 1099-K from PayPal. The contractor paid $2,500 in taxes on the $10,000 from the 1099-MISC. Their balance should be zero, but the IRS computer thinks the 1099-K was an additional, unreported $10,000 and sends a bill for another $2,500.
When the IRS sends the bill, it will contain information on how to appeal the finding that you owe additional tax. As long as you’ve kept good records, you should be able to quickly have the additional taxes reversed.
Is There a Way to Avoid Double Taxes If You Receive Both 1099-MISC and 1099-K?
Unfortunately, there is no certain way to avoid receiving a bill from the IRS for double-reported income. The IRS computers should already recognize that the income is from the same source. Any notices that are sent are due to shortfalls in the IRS system. The only thing to do is to ensure your return is accurate and your records are complete so that any audit or appeal can be swiftly resolved in your favor.
Do you need to include your 1009s in your tax return?
You generally don’t need to include a 1099-K or 1099-NEC with your tax return. It’s just for your information. The IRS also gets a copy so it can check if you reported all of your income.
Why do people think you need to attach your 1099 to your tax return?
There are no instructions from the IRS telling you to attach your 1099-K or 1099-NEC to your tax return. People who are used to filing W-2s may be confused, because you do need to attach your W-2. Some tax software also asks you to enter your 1099s.
Why does tax software ask for your 1099s?
Your tax software asks for your 1099s because it makes things easier for many people. If you just have a bunch of 1099s and haven’t added them up yourself, the tax software does it for you.
Where does your 1099 income go on your tax return?
Income from a 1099-K or 1099-NEC goes on your Schedule C. That’s the same place any sole proprietor income you need to report that isn’t on 1099 goes. And it’s just one box that asks for the total of everything.
So if you use bookkeeping software and know your numbers, you can just include your total sales here without worrying about your 1099s.
What’s the point of a 1099, then?
The point of a 1099-K or 1099-NEC is to make sure you don’t underreport your taxes. Those forms also go to the IRS and get entered into their computers. When you file your tax return, the IRS checks to make sure the income you reported before deductions is equal to or greater than the 1099s the IRS received.
If you report lower receipts or sales than what the IRS computer shows you earned, you’ll get a CP2000 notice for underreporting tax or other notice asking you why.
What happens if you get a 1099 after filing your taxes?
If you have multiple gigs or just a small side gig, it can be easy to forget about a 1099 when you file your taxes. This can cause a medium headache, but it’s not the end of the world.
What if you already reported the 1099 income?
You must report your income even if you don’t get a 1099, so hopefully you already did. For example, you should include any bank interest you earned even if you never got a 1099-INT. If you’re a sole proprietor, all income goes into gross receipts on your Schedule C regardless of if you receive a 1099-NEC.
If you included this income already, you’re good to go. There’s a small chance the IRS might have trouble matching the 1099 to your tax return and send you a CP2000 notice. You’d then just need to show them where you included that income on your tax return.
Note: Some DIY tax prep software asks you to input your 1099s and enter income not reported on 1099 separately. This is usually just to make the software easier to use. Generally, you do not file 1099s with your return. The tax software just adds up everything for you.
What if you forgot to report the 1099 income?
If you forgot about the income, you’ll need to report it. To do this, you’ll need to file a Form 1040X Amended Return.
First, you’ll need to complete or redo the schedule where the income belongs. For example, for 1099-NEC independent contractor income, you’ll need to fill out a Schedule C or redo your original Schedule C if you filled one out but forgot a client. You can also claim any available deductions related to that income if you didn’t claim them already.
After that, you’ll go through Form 1040X marking what stays the same vs. what’s different and redoing your tax calculations.
What if you don’t report the 1099 income at all?
If you receive a 1099 for income you forgot to include and don’t report that income, you will receive a CP2000 notice for underreporting your income. The IRS tracks all 1099s and matches them against what you reported on your tax return. Once the IRS computer detects that you underreported your income, the IRS will send you a bill for the additional tax due plus interest and penalties.
There are some people out there who would rather just let the IRS send them bill instead of filing an amended return. Keep in mind that interest and penalties will apply from the due date of your tax return. The longer it takes the IRS to figure out you owe money, the more you’ll owe. In addition, this could possibly increase your chances of a future audit or the IRS taking a closer look at things if you’re selected for an audit.
What can you deduct on your taxes when you’re self-employed?
Your deductions depend on what kind of business you’re in. These are some of the most common.
One half of your self-employment tax is deductible for income tax purposes. If you’ve already entered your business income and don’t see this deduction on line 27 of your IRS Form 1040, it’s time to change tax software or fire your tax preparer.
If you’re self-employed, the cost of your health insurance is an above-the-line deduction. This levels the playing field with employees who don’t need to include health insurance premiums paid by their employers in their gross incomes.
Self-Employed Health Insurance Deduction Requirements
The deduction is available if you…
- Had a net profit on Schedule C (sole proprietor), Schedule C-EZ, or Schedule F (farming).
- Were a partner with net earnings from self-employment.
- Had a loss but used an alternate method of calculating your income to get credit for Social Security.
- Were a 2%+ shareholder in an S-corporation and met certain technical requirements.
In addition, if you were were eligible to participate in a subsidized health insurance plan maintained by your, your spouse’s, your dependent’s, or your child under age 27’s employer, you may not claim this deduction even if you opt to not participate in that plan.
Self-Employed Health Insurance Deduction Amount
The deduction is generally the amount you paid in health insurance premiums. If you were only eligible for the deduction in certain months, you may only claim the premiums you paid for those months.
How Does the Self-Employed Health Insurance Deductions Work for S-Corporations?
S-corporations make things a little more complicated but end up in the same place.
- Buy health insurance through the business. You can’t buy coverage individually.
- The business can deduct that expense as compensation.
- Greater than 2% owners must include the value of their insurance plan in their taxable wages. This differs from regular employees who can exclude the health insurance premiums.
- Greater than 2% owners can deduct the cost of their health insurance policy as self-employed health insurance on Form 1040.
What if you have an Obamacare subsidy?
You may still be able to take the self-employed health insurance deduction if you have an Obamacare subsidy. The deduction is the amount of the premium you’re responsible for as calculated on your tax return for that year. It is calculated by subtracting your final subsidy amount from your total plan cost. It is not simply your monthly payment.
Example: Subsidy Higher than Expected
- You have a $100 per month policy with an $80 subsidy. You pay $20 per month.
- At the end of the year when you get your Form1095-A and complete your tax return, you find out you were eligible for a $90 per month subsidy.
- Your total health insurance cost for the year was $1,200. You received a $1,080 credit ($90 x 12). Your self-employed health insurance deduction is $120 ($1,200 – $1,080). It is not $240 ($20 monthly payment x 12).
- The extra $10 per month in subsidies ($90 – $80) that you didn’t receive during the year will be a separate $120 credit on your tax return. If you don’t owe tax when you file, you’ll receive a refund.
Example: Subsidy Lower than Expected
- You have a $100 per month policy with an $80 subsidy. You pay $20 per month.
- At the end of the year when you get your Form1095-A and complete your tax return, you find out you were eligible for a $70 per month subsidy.
- Your total health insurance cost for the year was $1,200. You received an $840 credit ($70 x 12). Your self-employed health insurance deduction is $360 ($1,200 – $840). It is not $240 ($20 monthly payment x 12).
- Since you received $10 per month more in subsidies than you were eligible for, you will need to repay $120 (12 x $20) as part of your Advanced Premium Tax Credit reconciliation when you file your tax return.
Self-Employed Health Insurance Obamacare Circular Calculation
One thing that you may notice is that if Obamacare subsidies are based on your AGI and your share of your premiums decreases your AGI, it results in a circular calculation. Every time you figure your deduction, it lowers your AGI, increases your subsidy, and in turn reduces your deduction.
The simplest way around this is to let your tax preparer or software do the calculation for you. If you do your taxes by hand, the IRS says to keep redoing the calculation until the change in your AGI is less than $1 different from your last calculation.
Can you deduct long-term care insurance?
Qualifying long-term care insurance plans are deductible up to limits that vary by your age. Here are the limits for tax year 2020:
- Age 40 or under: $430
- Age 41 to 50: $810
- Age 51 to 60: $1,630
- Age 61 to 70: $4,350
- Age 71 and over: $5,430
Home Office Deduction
If you used an area of your home exclusively for your business, don’t skip the home office deduction. This could include a portion of your electric bill and other utilities. Remember, your bills wouldn’t be as high if you were away from home during the day.
General Business Expenses
Did you maintain a website, buy office supplies, or spend money on advertising? Include these expenses on your Schedule C. Don’t forget transportation expenses between clients or other job sites.
Check out these guides for specific expenses for common gig jobs:
Qualified Business Income Deduction
The Qualified Business Income deduction is a new deduction created for 2018 and beyond by the Tax Cuts and Jobs Act. It gives small businesses who aren’t taxed as corporations a 20-percent income tax deduction.
Who is eligible for the Qualified Business Income deduction under Section 199A?
The Section 199A deduction is available to all types of businesses. This includes retail stores, manufacturing operations, lawyers, accountants, freelancers, and side gigs such as sports officials or rideshare drivers. For certain types of businesses, the deduction has income limits (more below).
What’s a pass-through business?
A pass-through business is a business that pays tax via its owner’s tax return. It’s basically any business type except a corporation or an LLC that chooses to be taxed as a corporation. Examples include:
- Sole proprietorships. This include independent contractors receiving a 1099 and filing Schedule C. You do not need to formally register a business to take advantage of this deduction.
How much is the QBI deduction?
The Section 199A deduction is up to 20 percent of qualified business income. In most cases, qualified business income is simply equal to your share of the profits.
For example, if you have $100,000 in sole proprietor profits, you get a $20,000 deduction. Remember that this is a deduction, not a credit. If you were in the 24% bracket, your actual tax savings would be about $4,800 ($20k x 24%).
The following items are not qualified business income, so you’d have to subtract them from your profit before calculating your deduction.
- Capital gains and losses.
- Certain dividends received.
- Certain interest income.
- Other items that aren’t effectively connected with the conduct of a trade or business within the United States.
What if your qualified business income is greater than your taxable income?
If your qualified business income is greater than your taxable income, the deduction is limited to 20% of your taxable income adjusted for capital gains. A common way this could happen is if you have above-the-line, AGI-reducing deductions such as 401(k) contributions.
What is a specified service business?
The Section 199A deduction is limited based on your income and whether you’re a specified service business.
A specified service business has traditionally meant professional service fields such as law, accounting, and engineering. The definition of specified service business also includes the phrase “where the business’s principal asset is the reputation or skill of one or more owners or employees.” So far, the IRS has generally not expanded specified service business beyond the list of businesses in the statute.
What are the income limits for the Qualified Business Income deduction?
The deduction has limits based on your total taxable income. The below numbers are the starting point and adjust for inflation each year.
Total taxable income means all of your income not just your qualified business income. For example, a married filer with $450,000 in wages and $10,000 in qualified business income would use the greater than $415,000 threshold.
All Businesses: Income Up to $157,500 (Single) or $315,000 (Joint)
The calculation is simply 20% of qualified business income. If your income is within this range, you get the full deduction even if you’re a specified service business.
Specified Service Businesses with Higher Incomes
The deduction gradually drops from 20% to 0% as you go from $157,500/$315,000 to $207,500/$415,000. Unlike tax brackets, the same percentage applies to your entire income. If you’re a single filer with $207,501 in qualified business income, you do not get a single cent from the deduction.
All Other Businesses with Higher Incomes
For other businesses, the calculation is more complex at higher incomes. The deduction if you’re above $207,500/$415,000 is the lowest of:
- 20% of qualified business income.
- 50% of W-2 wages paid.
- 25% of W-2 wages paid plus 2.5% of the basis at acquisition of qualified property (that you use in the business and isn’t fully depreciated).
If you’re between $157,500/$315,000 to $207,500/$415,000, the two calculation methods are blended together.
How does the section 199A deduction work for partners and multiple shareholders?
Even though the Section 199A deduction is for business income, you qualify based on your personal income. Each partner or shareholder calculates their own deduction based on their own share of the profits and their other personal income. A partner can be eligible even if the other partner isn’t. Further, the income limits are based on each individual’s own income rather than the business’s total income.
Section 199A Deduction Planning
Because of the complex rules governing eligible business types, phaseouts, and cutoffs, smart tax planning is critical to maximize this deduction. For example, a specified service business owner might be able to go from no deduction to a full 20% by putting more money into a tax-deferred retirement account. Other businesses may see a benefit from splitting different portions of the business into separate business entities.
Did you contribute to a retirement plan during the year? See if you qualify for up to $1,000 via the Saver’s Credit. Don’t forget that you can also reduce your AGI by contributing to a traditional IRA, SEP IRA, or individual 401(k).
The easiest options are a personal traditional IRA or increasing your contribution to your salaried job’s 401(k) if you have one. If you don’t have access to a 401(k) or need to contribute more, you may want to open a SEP IRA or individual 401(k). These are special types of retirement plans for small business plans including sole proprietors with no employees.
How do you choose between a SEP IRA and individual/solo 401(k)?
These are the traditional considerations when choosing between a SEP IRA and Solo 401(k).
- Ease of opening: Many providers allow you to open a SEP IRA instantly online like a personal IRA or bank account. Solo 401(k)s virtually always require mailed or faxed forms.
- Ease of contributions: Most SEP IRAs allow you to schedule automatic withdrawals from a personal or business bank account and make changes at any time. Solo 401(k)s often have restrictions on the bank account you can use, may require you to mail or fax a form to make changes, and some even require a physical check for contributions.
- Opening deadline: You have to open a Solo 401(k) by the end of the tax year (usually December 31st). You have to open a SEP IRA by the time your tax return is due (usually April 15th). This gives you more time to open a SEP IRA.
- Cost: There are many free SEP IRA options available. Most Solo 401(k)s have setup and/or ongoing administration fees.
- Investment options: SEP IRAs are usually an unrestricted brokerage account allowing you to use your choice of stocks, ETFs, and mutual funds. Some solo 401(k)s have a brokerage option, while others require you to choose from a fixed list of mutual funds.
- Employee contribution limits: Solo 401(k)s allow you to contribute up to $19,000 as an employee. SEP IRAs do not allow employee contribution limits, although many SEP IRAs can also accept your regular personal IRA contributions into the same account.
- Employer contribution limits: Both SEP IRAs and Solo 401(k)s allow you to contribute up to 20% of your compensation as the employer.
- Roth option: Solo 401(k)s allow a pre-tax deductible option and a post-tax Roth option. SEP IRAs do not allow a Roth option, although you can convert your contributions to your Roth IRA if you choose to do so.
Based on that information, most people chose SEP IRAs. The most compelling reasons to go with a Solo 401(k) were if you wanted the higher employee contribution limits or if you wanted the Roth option.
What Changes with the QBI Deduction?
The biggest wrinkle in the current tax code is that retirement contributions you make as an employer reduce your qualified business income, but contributions you make as an employee don’t.
Example: Your qualified business income is $60,000 per year and you want to save 10%.
- If you put $6,000 into a personal IRA or into a Solo 401(k) as an employee, your QBI is still $60,000, and your QBI deduction is $12,000.
- If you put $6,000 into a SEP IRA or into a Solo 401(k) as an employer, your QBI is reduced to $54,000, and your QBI deduction is $10,800.
Therefore, you want to prioritize personal IRA and Solo 401(k) employee contributions over SEP IRA and Solo 401(k) employer contributions to get a bigger tax deduction.
What About Roth Contributions?
Since you can only make Roth contributions into the employee portion of your Solo 401(k) or into a personal Roth IRA, they don’t directly impact your QBI deduction.
However, the QBI deduction makes Roth contributions more valuable. The QBI deduction does not apply to taxable distributions from your retirement account. If you skip it to make tax-deductible retirement contributions, you lose it.
Example: You’re in the 22% tax bracket and will be in retirement.
- If you choose the Roth option and pay the tax this year, your effective tax rate after the 20% deduction is 17.6% (22% x 80%).
- If you choose the deductible option, you pay the full 22% tax rate in retirement.
Remember, the usual rule for Roth contributions is to use them when you expect your tax rate today to be lower than your tax rate in retirement.
What About Roth Conversions?
In the past, if you wanted to do Roth contributions and not deal with the hassle of a Solo 401(k), you could contribute to a SEP IRA and convert it to a Roth IRA in the same year. Your deduction for the SEP IRA and the tax on the conversion offset each other, so it was like you just contributed to a Roth IRA in the first place.
Currently, you lower your QBI deduction by doing so. The SEP contribution reduces your QBI deduction as usual. The conversion is taxed as ordinary income without the benefit of the QBI deduction.
- $10,000 employee contribution to a Solo 401(k): receive a $2,000 QBI deduction (20% x $10,000) and pay income tax on $8,000 ($10,000 – $2,000).
- $10,000 contribution to SEP IRA converted to a Roth 401(k): $10,000 is deducted from your business income, so no QBI deduction. The conversion is taxed as ordinary income, so you still pay income tax on $10,000 ($10,000 – $0).
Bottom Line: SEP IRA vs. Solo 401(k)
With the QBI deduction in play, Solo 401(k)s give you more tax maneuverability that may make them worth the hassle when they weren’t in the past. However, SEP IRAs are still the easier option if you don’t need to make one of the above moves or think the tax benefit doesn’t outweigh the extra hassle.
What are estimated taxes?
Most people think of April 15th as the due date for taxes, but the reality is that the IRS wants its cut as soon as you get paid. If your income isn’t covered by income tax withholding, you need to make estimated tax payments.
Who has to pay estimated taxes?
You need to pay estimated taxes if you will owe $1,000 or more when you file your tax return. You may not need to pay estimated taxes if you had no income or tax liability the previous year, but it’s good to do anyway to avoid a surprise tax bill.
Common reasons for having to pay estimated taxes include running your own business or having a gig economy side gig that classifies you as an independent contractor like being a rideshare driver, grocery shopper, or sports official.
What happens if you don’t pay estimated taxes?
If you don’t pay estimated taxes, there are two possible penalties depending on when you actually pay.
Missed or Late Quarterly Payment
The underpayment of or failure to pay estimated tax penalty applies between the estimated tax payment due date and your tax return filing due date. This is an interest charge. The rate is about 2-3% higher than the current federal funds rate depending on rounding and when it was last changed.
Not Paying By Your Filing Deadline
The failing to pay penalty applies if you don’t pay your taxes by your tax return due date. The penalty is 0.5% per month of the outstanding balance. Interest charges also apply on top of this penalty.
How much should your estimated tax payments be?
Your estimated tax payments depend on your income and business type.
- Default Rule: Most people can avoid estimated tax penalties by paying at least 90% of their current year tax or 100% of their previous year tax.
- High Income: If your AGI is greater than $150,000 ($75,000 if married filing separately), you must pay either 90% of your current year tax or 110% of your previous year tax to avoid estimated tax penalties.
- Farmers or fisherman: If at least 2/3 of your income is from farming or fishing, you can avoid estimated tax penalties by paying either 2/3 of your current year tax or 100% of your previous year tax.
- Household employers: If you have a household employee, include their household employment taxes when calculating your estimated tax payments.
Most people make four equal payments. If your income is uneven, you can annualize your income to match your estimated tax payments to when you actually earned the income. This requires extra paperwork and usually isn’t worth it unless your income is highly variable.
When are estimated tax payments due?
Estimated taxes for calendar year filers are due in quarterly installments on the following dates.
- April 15.
- June 15.
- September 15.
- January 15 (for the 4th quarter of the previous year).
See Coronavirus Tax Relief for special extensions for 2020.
Note that the deadline may extend by a day or two if it falls on a weekend or federal holiday.
The easiest way to make estimated tax payments is to make four equal payments on those dates. If you don’t pay the full installment by the quarterly due date, you’ll owe an underpayment of estimated tax penalty. This penalty is smaller than the penalty for not paying in full by your tax return due date, and some people view it as a reasonable interest rate to wait to pay until April 15th. However, depending on your level of financial discipline, you may find it easier to go ahead and pay to avoid being short on funds later.
What income requires quarterly tax payments?
Estimated tax payments cover your total tax liability. Therefore, you should consider all of your income when calculating your estimated tax payments. This includes:
- Wages (usually covered by employer withholding).
- Self-employment income.
- Farming and fishing income.
- Bank interest.
- Investment dividends and capital gains.
- Taxable alimony.
How do you calculate estimated tax payments if you have withholding at a W-2 job?
If your employer withholds income tax, that withholding counts towards your estimated tax obligation. That’s why most employees don’t have to worry about estimated tax payments.
If you have a side job or rental property that only makes up a small portion of your income, you may be able to increase your withholding to avoid having to make a separate estimated tax payment.
To figure your estimated tax payments when you have withholding, take your total tax liability, subtract your expected withholding, and the difference is your estimated tax payment.
Is it better to use this year’s or last year’s income?
It is almost always easier to use last year’s income because all you need to do is divide the tax liability on your last tax return by four and make four equal payments. However, this method could leave you short if your income increases. To avoid this, use a tax calculator to estimate your current tax year liability and either set aside the additional amount in a savings account or make an extra estimated tax payment.
If your income decreases, you have the option to switch to the current-year method later in the year.
What if you pay too much?
If you pay too much because your income went down or you overestimated how much you need to pay, you can receive a refund when you file your final tax return just like you would if your employer withheld too much. You can also opt to apply your refund to your estimated payments for the next tax year.
There is no way to get an early refund if you significantly overpay your estimated taxes. If your income is unpredictable, you may
Where do you send payments?
The IRS has a number of payment options. The easiest option is to set up an account with EFTPSbecause you can schedule your payments in advance and have them automatically withdrawn from your bank account on the due date. Note that the initial EFTPS setup takes a few weeks because the IRS sends a PIN by mail that you must have to log in to your account.
To make payments by mail, fill out Form 1040-ES and send your payment along with the payment voucher to the address listed on the form.
Payments by credit card are possible if you’re short on funds. However, the approximately 2% processing fee combined with possible interest are probably greater than the IRS penalties as long as you’ll be able to pay your full tax liability by April 15th.
What’s the best way to handle quarterly tax payments?
- Open a savings account just to hold money you’ll use for estimated taxes.
- Divide your previous year’s tax liability by 52 and schedule weekly transfers from your checking account into this savings account. Don’t forget to make a catch up transfer if you set this up after January 1st.
- Use EFTPS to automatically withdraw your quarterly estimated tax payments from the savings account. The withdrawal should be 25% of your previous year’s tax liability.
- You’ve now met your estimated tax obligation by paying 100% of your previous year’s tax liability. (If you’re required to pay 110%, set your quarterly payments to 27.5% instead.)
If your income goes up or your deductions are lower, you’ll have a small April 15th tax bill, but you won’t have to pay a penalty.
Can you have your estimated tax payments automatically transferred to a different bank account?
There are a few ways to set aside your estimated tax payments.
- Catch is a new app that identifies payments into your bank account and automatically withdraws a fixed percentage. This can be a more accurate way of figuring out how much to pay especially if your income is highly variable. Catch also automatically makes your estimated tax payments for an additional fee. To me, the cost is not worth it. In addition, there have been similar apps in the past that haven’t lasted long. I’m not optimistic even though the tool is useful in theory.
- Old-fashioned scheduled savings account transfers work as described above. If your income projections increase or decrease, you can change your transfer schedule or move money accordingly.
- You can also use a budgeting app instead of a separate savings account to allocate money to estimated taxes. You still need to set up the budget amounts, but it can avoid the hassle of maintaining a separate bank account if you’re disciplined about sticking to your budget.
If this seems like too much math or you’re still not sure what you need to do, you may want to talk to your tax accountant.
What about payroll taxes?
If you collect payroll taxes, including on your own wages (that your business will report on a W-2), the deadlines range from quarterly to semi-weekly depending on your total payroll. This generally only applies to your own pay if you’ve incorporated. It will almost always apply if you hire employees.
Unlike other taxes, the penalties for not depositing payroll taxes on time are severe and can include possible criminal charges. While you can delay paying income taxes knowing that you’ll owe a little interest, it is never a good idea to do this with payroll taxes.
How do I file my tax return?
Most self-employed people will need to add a Schedule C to their Form 1040 individual tax return. If you’ve formed a partnership or S-corporation, you may need to file a Form 1065 or Form 1120-S.
It’s possible to file your return on your own, but most commercial tax preparation software is only capable of handling the simplest businesses. Many small business deductions and tax rules have exceptions, unclear definitions, or other things that are hard to do correctly using check-the-box software if you have no tax knowledge.
Who can you use to file your taxes?
These are some of the common online tax filing services that support Schedule C filers.
|Feature||Credit Karma||H&R Block||Liberty Tax||TaxAct||TaxSlayer|
|IRS Free File?||N/A||No||No||Yes||Yes|
|Schedule SE (Self-employment tax)||Yes||Yes||Yes||Yes||Yes|
|Live Help||No||Additional cost||No||Additional cost||Basic support included|
Credit Karma is fairly new to the tax filing game. They are of course one of the largest providers of free credit monitoring services.
One thing about Credit Karma that some users may be comfortable with is that their business model is to collect financial data from their users for third-party marketing. This includes credit card or loan offers within their software. They also sell aggregated data to third parties.
H&R Block is most popular for their bricks and mortar tax filing locations. Their online filing services are fairly new.
When you go to an H&R Block store, your tax preparer generally reads from a set of scripted questions and plugs your answers into their computer. The online version gives you similar questions except instead of giving your documents to the preparer, you enter them when the software tells you to. If you do want that human touch, H&R Block does have online filing with a human tax preparer for an additional charge.
Another feature of H&R Block is that they offer automatic importing from some large gig employers such as Uber. You may also qualify for discounts or even receive the service free if the company you contract for has partnered with H&R Block.
Another thing to note with the service is that if you only have 1099 income and no business expenses, you may qualify for a less expensive tier than the Self-Employed tier.
You may be familiar with Liberty Tax from the people dressed as the Statue of Liberty spinning a sign. Once you’re inside, Liberty Tax is a similar experience to H&R Block.
Liberty Tax has multiple tiers like H&R block. Most Schedule C filers will need to use the most expensive Premium tier.
TaxAct is my personal choice. They’re a longtime provider of online tax returns.
The interface is very easy to use. If this is your first time filing self-employment income, the questions should guide you through everything you need.
One big advantage to TaxAct is that it is one of few providers that allows Schedule C filers to use the IRS Free File program. It also has one of the highest AGI limits to qualify for Free File. Be sure to check if you qualify before you sign up for the paid version.
TaxSlayer isn’t quite new, but they’re one of the lesser known online tax services. A big advantage to TaxSlayer is there is no upcharge for guidance with your 1099 income.
The online support won’t give you the same level of support as if you made an appointment with a CPA or EA, but it could be right for you. You might just have a few questions or want to double check to make sure you’re on the right track instead of wanting someone else to do everything for you.
TaxSlayer also has an offer through the IRS Free File program if your income qualifies.
What should you consider when considering online tax software?
- Cost: All the major online tax filing companies are very similar. If one is free or substantially cheaper, it’s probably a good choice.
- Live support: If you don’t want to be completely on your own, consider a service that offers live support. However, you may want to give the self-service version a try to see if you actually do need to pay for that extra help.
- Guarantees: Most online providers will provide a guarantee that you will get the biggest refund and/or that they’ll defend you in an audit. However, this is usually limited to their errors. For example, they had a math error in a form or had incorrect guidance in their questions. You can also sometimes purchase audit defense services for your errors.
- State returns: If you need to file a state tax return in one or more states, check that they support your state.
- Other tax forms: You may have other uncommon types of tax situations such as retirement account withdrawals, rental properties, or income from a partnership or corporation you own. You’ll also need to check if each provider offers those forms and whether they charge more to add them.
How do I file my taxes for a specific gig?
You can check out these guides for more information.
What are common mistakes people make when filing their own taxes?
Not Paying Estimated Taxes
The federal tax system is pay-as-you-go, if you don’t have income tax withholding through an employer, you need to make quarterly estimated tax payments to cover your tax bill.
If you don’t make estimated tax payments totaling between 90 to 110% of your income tax liability (depending on your income and whether you’re using this year’s or last year’s income), you could have to pay additional interest.
And of course, if you don’t have the money by April 15th, you could pay additional interest and penalties on top of that.
Claiming Personal Expenses as Business Expenses
Many new sole proprietors hear that things like mileage and phone bills are deductible and start deducting them in full. In fact, there are very strict rules that you need to follow.
The main rule is that you can only deduct the business portion of the expense. So for your phone bill, you’d need to figure out how much you use it for personal reasons versus how much you use it for business reasons and only deduct the portion of your bill attributable for business reasons. For mileage, you need to learn the rules for what constitutes business mileage and make sure that you’re not deducting commuting miles between the business and your home.
Improperly Claiming the Home Office Deduction
The home office deduction os one of the most heavily audited deductions because most people simply do it wrong. To claim it, you must have a portion of your home that you use for nothing but business and meet other IRS rules. You also must have supporting documentation for both your business use and the expense that you claimed.
Expensing Large Purchases All at Once
Even if you’re a cash-basis taxpayer, you may be required to depreciate large purchases over time rather than deducting the full purchase price in the year of purchase. The good news is that the Section 179 election allows you to skip doing this if you don’t make millions of dollars in revenue, but you need to follow the defined procedures to make the election.
Not Reporting Expenses
Don’t skip reporting expenses because you’re afraid of an audit. An audit isn’t that bad as long as you have your receipts and other documentation.
In addition, the tax laws require you to claim your allowable business expenses. This is to avoid people abusing things like the Earned Income Tax Credit, Social Security, and other income-based benefits.
Mixing Personal and Business Expenses
You’re only required to have a separate bank account if you’re a corporation or other legally-separate entity. However, it’s still a good practice if you’re an individual Schedule C filer.
Keeping a separate bank account makes tracking everything easier and reduces what you need to provide to the IRS if they audit your business expenses.
Forgetting Payroll Taxes
If you’re a Schedule C filer, you don’t need to pay payroll taxes for yourself because you don’t take wages. You pay Social Security and Medicare taxes based on your business profit.
However, if you hire employees, you’ll need to obtain an EIN and make payroll tax deposits anywhere from weekly to quarterly depending on your payroll. Failing to do so can result in severe fines and possibly even criminal charges.
Do I need to open a separate bank account to manage self-employment taxes?
It’s almost always a good idea to have a separate business bank account for business expenses. This separates them from personal expenses and makes your accounting even easier.
If you have periodic 1099 income with few expenses, you may be able to open a second personal checking account with your usual bank. For more complex needs or heavy transaction volumes, you’ll definitely need to open a small business checking account.
What kind of accounting software do I need?
For basic gigs with minimal expenses, a spreadsheet or separate category in your personal budgeting software will do. If you need a little more tracking, QuickBooks Self-Employed has automatic transaction imports, categorization, mileage tracking, and estimated tax calculations and reminders.
If you have a small business with more complex accounting needs, check out this guide to accounting software for small businesses.