According to a study by the Freelancers Union, over 53% of the American workforce is involved in some kind of freelance work.
There are now more incentives for freelancers to strike out on their own with the Tax Cuts and Jobs Act passed by the United States Congress in December 2017. Many freelancers who operate using a partnership, S Corporation, or even as a sole proprietorship structure will have a lower tax liability while the law is in effect, and the Act is set to expire in 2025.
Businesses sometimes pay freelancers (working as independent contractors) a higher pay rate than W-2 employees for a given project, which results in a higher taxable income for the freelancer. One of the drawbacks to freelancing is accounting for the various types of taxes you’ll have to pay, including:
- Federal taxes
- State taxes
- Social security taxes
- Medicare taxes
Freelancers also forfeit company-provided employee benefits such as health insurance, paid time off, and retirement plans, among others. They are typically hired to complete a specific project for a set amount of time, rather than perform consistent work as an employee. Full-time freelancers must pay for their own insurance, and fund retirement plans as individuals.
Many workers, however, are opting to combine both styles of work. In addition to having a full-time job with a consistent salary and healthcare benefits, many are also juggling freelance projects as part-time, independent contractors for extra income. If you work as a salaried worker and a freelancer, you must file a Form 1099 along with your regular tax return.
Here’s what to expect when you have both 1099 and W-2 income, plus some ways to simplify your business and personal tax returns at the end of the year.
The differences between a W-2 and 1099
First, it’s important to distinguish between a 1099-MISC and a W-2. Organizations may employ two types of workers — employees and independent contractors. Form 1099-MISC is the tax form you receive from a company you contract with, and Form W-2 is the tax form you receive as an employee.
The major difference between these two documents is the potential tax consequences. Bottom line? Companies don’t withhold taxes for independent contractors who are issued 1099-MISC forms, and the payments are considered self-employment income.
A Form 1099-MISC will show the full gross income paid to you, whereas a Form W-2 will report gross wages and the taxes withheld by the employer throughout the tax year.
When taxes are withheld, your tax liability is reduced, which may result in a tax refund from the IRS.
How will this affect my taxes?
Workers pay a 15.3% FICA tax, which is used to fund Social Security and Medicare. As an employee with a W-2, you pay 7.65%, and your employer pays the other 7.65%.
As a contractor with a 1099-MISC, however, you’re responsible for the full 15.3% of the “self-employment tax”, and you can deduct the one half of the self-employment tax on your personal tax return (Form 1040).
While your tax return is more complicated as a freelancer, you gain flexibility and autonomy, and a greater degree of control over the work you do.
The new tax law puts new limits on some business expenses, including meals, entertainment, and transportation costs. However, the Tax Cuts and Jobs Act lowers tax rates for seven income tax brackets, which means that taxpayers will have a lower tax liability on each dollar of taxable income.
The limits on business expenses will increase taxable income, while lower tax rates will reduce the tax liability on a given amount of income. These changes will produce a variety of outcomes for taxpayers, depending on your personal situation.
As an example, the deduction for state and local taxes is now limited. Taxpayers cannot claim more than a $10,000 deduction for the aggregate of property taxes and either income or sales taxes. As a result, individuals in states with a high rate of state taxes will have their deductions limited, and their tax liabilities will be higher.
If you earn wages as an employee and work as a freelancer, it’s important to remember that the employer pays a share of FICA tax on wages, and you personally deduct the employer share of FICA tax on your freelancer (1099) income.
If I have both types of income, how do I pay taxes on my 1099?
Partnerships, S Corporations, and sole-proprietorships are referred to as “pass-through entities” because business income is passed through to the individual’s personal tax return. The new tax law provides a deduction on income generated through these businesses.
If you operate using a pass-through entity, you can deduct 20% of your “qualified business income” from your total income. This deduction reduces your taxable income and generates a lower tax liability. Check with an accountant to determine what should be included as qualified business income.
In addition, the standard deduction for single filers has nearly doubled to $12,000 from $6,350, and the deduction increased from $12,700 to $24,000 for joint returns. This change provides tax relief for middle-class taxpayers who use the standard deduction.
If your main source of income is a full-time job with a salary, the extra income you earn on a freelance basis is eligible for the special tax treatment, as long as you operate using a pass-through entity.
Perhaps most important, your 1099 income does not include any tax withholdings, and you need a plan to pay taxes on your freelancing income. This is true, whether you work full-time as a freelancer, or you freelance and work as a salaried employee.
Here are some options for tax planning:
1. Withhold more of your W-2 income
If you increase your tax withholdings on your wages, you can use those dollars to cover the tax liability to generate as a freelancer.
To do this, ask your employer for a new Form W-4. You file Form W-4 when you first start working for your employer, and it helps the employer figure out how much they should withhold in taxes for you. In order to offset your 1099 income, you can ask your full-time employer to withhold more taxes from each paycheck you receive.
The upside to this is the convenience since you don’t have to remember to pay quarterly taxes yourself. The downside is that it isn’t very accurate, so your employer may over-withhold taxes (meaning your paycheck wouldn’t be enough to meet your personal expenses) or under-withhold taxes (meaning you may get hit with a tax bill for the underpaid amount). Talk to your HR department for more information.
2. Pay taxes quarterly
The second method to pay taxes on freelancer income is to make estimated tax payments every quarter to the IRS.
If you owe taxes, you can set up a payment plan to make payments every quarter. This way, you won’t have to pay the amount owed in one lump-sum, and you can estimate your payments every quarter, based on your income.
3. Pay a penalty at the end of the year
If you don’t change your W-4 to have more taxes withheld, or pay quarterly taxes on your 1099 income, you may be forced to pay a penalty on the amount you underpaid when you submit your personal tax return on April 15th.
The IRS requires that your tax withholdings and estimated tax payments must total at least 90% of your tax for the current year, or 100% of your tax for the prior year, whichever is smaller. If you don’t meet this requirement, you must pay a penalty.
Earn, Learn, and Save
Whether you’re a business owner, a freelancer, an employee or a combination of both, understanding how income payments are categorized can save you from making costly mistakes this tax season.
No one wants to pay more taxes or fees to the IRS than necessary, so make a decision to pay quarterly taxes, or withhold enough from your regular paycheck to cover any additional taxes.
Tax preparation may not be a fun process, but your bank account will thank you at the end of the year when you can keep more of your hard-earned money.
The TurboTax and QuickBooks Self-Employed bundle can help remove stress by automatically calculating your quarterly taxes for you.