Complete Guide to Taxes for the Self-Employed
In the past decade, the self-employment industry has grown more rapidly than any other employment segment. This has created loads of income opportunities for individuals to work for themselves and find the financial freedom they crave.
The only offset with this freedom is the responsibility of having to organize your income and expenses as well as file your own taxes. The process is a bit different from a traditional job, in which you only receive a W-2 at the end of the year, because when you’re self-employed, you receive a 1099 and are responsible for tracking any expenses to determine if you’re eligible for a tax deduction. While accounting software can handle these tasks for you, it’s also good to know the process if you’d prefer to prepare taxes yourself.
IRS Tax Forms Freelancers Need to Know
At the beginning of every year, companies and employers are required to send out tax forms to everyone they paid out money to throughout the previous year. This includes independent workers who performed contracted work.
Here are the type of IRS forms you should look out for, and what each one means for your tax situation.
Tax Form 1099-MISC
Form 1099-MISC summarizes any miscellaneous income you have, including income you receive while working as an independent contractor.
The most common type of 1099 income is from independent contracting work. Companies typically give a contractor a 1099-MISC if they pay him or her over $600 during the tax year.
However, many companies now say their contractors fall under the rules for a 1099-K, which is the form of 1099 for people who accept credit-card payments from customers via PayPal or other payment processor. You must make over $20,000 and receive over 200 payments in order to receive a 1099-K. So unless you’re getting paid daily, it’s unlikely you’ll receive one.
If you don’t receive a paper form, does this mean you don’t have to pay taxes? Unfortunately not! Your company still reports all of your payments to the government. It just means you report those earnings yourself on your Schedule C.
Keep in mind that, unlike traditional workers, you don’t withhold any taxes from your monthly pay, so you need to save money on your own to pay your taxes. How much you’ll ultimately pay depends on a lot of factors, but you should calculate and pay estimated taxes every quarter if you want to avoid an audit and/or fines.
A Schedule C is a tax form filed with your personal tax return, in which you calculate the profit or loss from your business. You’ll tell the government how much you made (earnings), how much you spent (expenses), and if that resulted in a profit or loss.
A Schedule C-EZ is just a simplified (“easy”) version. You can use the C-EZ only if you meet certain requirements. The major requirements are that you only run one type of business and don’t have more than $5,000 in business expenses.
You must include a Schedule C or C-EZ with your Form 1040 during year-end taxes. You might also complete one when filing quarterly taxes using a 1040-ES (discussed below).
Part I: Income
The first part of the Schedule C is where you report your earnings. You’ll notice some fields like “Returns” and “Cost of Goods Sold.” These are only applicable when you’re selling a physical product, so these don’t apply to service or on-demand workers.
If you did receive paper 1099s, you do not need to submit them with your taxes. You should, however, keep them for your records. If you didn’t receive a 1099, you still need to report and keep proof of your income (e.g. proof of bank deposit).
Parts II to V: Expenses
This is where you’ll record any expenses related to the aforementioned income.
Tax Form 1040-ES
As a traditional employee, your employer withholds your taxes from every paycheck and submits them to the government on your behalf. As a self-employed professional, no taxes are withheld when you’re paid. This means you need to pay taxes to the government yourself. The question is: How often?
Generally, most independent contractors have to submit taxes to the government every quarter. There are some specific regulations for this, but generally you have to pay quarterly taxes if you expect to owe $1,000 or more in taxes for the year (roughly, if you plan to make more than $5,000 in 1099 income).
If you do have to pay quarterly taxes, the due dates are:
What if you didn’t pay quarterly taxes or actually owe far more than you estimated? You’ll typically pay a 6% to 8% penalty on the amount you underpaid. (So if you made $10,000, owe $2,000 in taxes and didn’t pay quarterly taxes, you might be subject to a penalty of 6% of the $2,000 underpayment, which is $120).
What if you can’t pay your taxes? The IRS is surprisingly accommodating when it comes to this—as long as you’re open and upfront about it. If you’re in trouble or need help, you should definitely talk to a tax professional or CPA as soon as possible and have them work out a payment plan or extension with the IRS.
To file your quarterly taxes, you’ll use a Form 1040-ES to estimate how much you’ll make during the year and how much tax you expect to pay on those earnings. Then, you pay a portion of that each quarter. You should complete a 1040-ES each quarter when you pay estimated taxes. This is because your estimated income for the year might change over the course of three months (e.g. if you start working more or less often).
There is also a “safe harbor rule”: If you expect to make more this year than you did last year, the government only requires you to pay at least 100% of what you paid last year (110% if you make more than $150,000). You’ll still have to pay the full amount of what you owe at the end of the year, but this effectively gives you an interest-free loan until the end of the year when you pay the remainder.
Schedule SE will help you calculate how much you owe in self-employment taxes.
What are these? About 15% of everyone’s income goes towards supporting Social Security and Medicare (this is called the “FICA” for employees or “SECA” for self-employed tax). When you’re an employee, you pay around 7.5% and your employer pays the other 7.5%. When you’re self-employed, you pay the full 15% yourself, which is nicknamed the “self-employment tax.”
Tax Form 1040
Form 1040 is where you’ll report your income and deductions for the year, so you can calculate how much income tax you owe. This is completed at year-end and is due on April 15.
Why are quarterly tax forms due on January 15 and your 1040 due on April 15? This is because the 1040 is much more in-depth with its deductions and calculates the official amount of tax you owe for the year. Your quarterly taxes are just estimates so the government can collect cash throughout the year. (Remember: The government’s “income” comes from taxes. Imagine if your company only paid you once a year—you’d probably be in financial trouble.)
Some expenses you have as an independent contractor will go on the 1040 instead of on your Schedule C. For example, if you pay for your own health insurance and aren’t eligible for a spousal or employer-sponsored plan, you’ll be able to claim that as an above-the-line deduction on your 1040.
Preparing Self-Employed Quarterly Taxes
If you’ve been an employee before, you know your employer withholds taxes from your pay before you receive a paycheck. They then send those taxes to the government on your behalf on a monthly basis. As a contractor, taxes aren’t withheld from your pay; however, the government still wants to get paid throughout the year, so they require you to send in your own quarterly taxes with Form 1040-ES (discussed above).
Most independent contractors have to pay quarterly taxes. The easiest way to tell is with the $1,000 test:
- If you expect to owe more than $1,000, you’ll probably have to pay quarterly taxes.
- If you expect to owe less than $1,000, you probably won’t have to pay quarterly taxes, but you will have to pay year-end taxes.
In both cases, you’ll calculate your final official tax payment when you do your year-end taxes. Depending on how much you paid throughout the year, you might over or underpay. But what happens then?
- If you overpaid on quarterly taxes, you’ll get a refund at the end of the year.
- If you underpaid on quarterly taxes, you’ll pay the difference at the end of the year, plus penalties and interest.
You only owe taxes on your business profit, which is business earnings minus business expenses. Make sure you’re keeping good track of these, since if you don’t track your business expenses, you’re losing money to taxes you can’t get back.
In most cases, if you underpay your taxes throughout the year, you’ll be subject to fines and penalties at the end of the year. These can be as much as 10% for federal, plus another 10% for your state. So if you owed $5,000 in federal taxes and $1,000 in state taxes and didn’t pay throughout the year, you could owe up to $600 in additional fines and penalties.
Preparing Self-Employed Year-End Taxes
On an annual basis, you’ll calculate your final taxes for the prior year. If you owe less than you paid in quarterly tax payments, you’ll get a refund; if you owe more than you paid in quarterly taxes, you’ll owe more money to the government. You’ll fill out a Schedule SE to calculate your self-employment taxes, plus Form 1040 to calculate your federal income tax. You may also need to calculate state or local income taxes.
Understanding the Self-Employment Tax
As previously mentioned, part of everyone’s income goes towards supporting Social Security and Medicare. This is called the “FICA tax” if you’re an employee or “SECA tax” if self-employed. When you are an employee, you pay about 7.5%, and your employer pays another 7.5% for you. When you’re self-employed, you pay the full 15% (actually 15.3%) yourself, hence why it’s nicknamed the “self-employment tax.”
For contractors, your self-employment tax is calculated on a Schedule SE (SE stands for self-employment). After you calculate your net profit on your Schedule C (your earnings minus expenses), you’ll then calculate how much of that is subject to self-employment tax.
The tax is used to fund the nation’s Social Security and Medicare programs. These are programs that take care of you after you retire or if you become permanently disabled. As mentioned earlier, all wage earnings in the U.S. must contribute to these programs.
Now that you understand that you must file taxes on income as you earn it, as well as contribute an extra portion for your part of Social Security and Medicare, you can better prepare for the tax-filing season.
This will help ensure you don’t have to pay additional fees or penalties for underpaying your taxes and can keep more of your hard-earned money. Use this self-employment tax guide in conjunction with accounting software to accurately track your expenses and income, calculate your quarterly taxes and have a smooth tax-filing experience. For more tax-time tips, see our articles on avoiding an audit and filing taxes when you have both 1099 and W-2 income.