Self-employment offers the opportunity to be your own boss and establish a lifelong bond with your accountant. If you’re self-employed, you will need to pay your own FICA taxes and manage your retirement plan, among other responsibilities. Here are some essential tax planning tips for the self-employed.
Understand Self-Employment Tax and How It’s Calculated
Ensure you understand your federal tax responsibilities. Self-employment tax funds Social Security and Medicare benefits. If you have more than a minimal amount of self-employment income, you must pay this tax. For sole proprietors, independent contractors, or statutory employees filing a Schedule C, the net profit on your Schedule C (or Schedule C-EZ) is self-employment income and must be included on Schedule SE, filed with your federal Form 1040. Schedule SE calculates and reports the self-employment tax owed.
Make Your Estimated Tax Payments on Time to Avoid Penalties
Unlike employees, who have taxes withheld from their paychecks, self-employed individuals must make quarterly estimated tax payments using IRS Form 1040-ES to cover federal income tax and self-employment tax liability. State-estimated tax payments may also be required. Failing to make these payments can result in penalties, interest, and a large tax bill at the end of the year. Refer to IRS Publication 505 for more information on estimated tax.
If you have employees, you have additional tax responsibilities, including paying federal employment taxes and reporting certain information. Consult IRS Publication 15 for details.
Employ Family Members to Save Taxes
Hiring a family member to work for your business can create tax savings by shifting business income to your relative. Your business can deduct reasonable compensation paid to an employee, reducing your taxable business income. However, the IRS may question compensation if it seems unreasonable based on the services performed. Additionally, comply with child labor laws when hiring minors.
As a business owner, you are responsible for paying FICA taxes on employee wages, which are deductible business expenses. However, if you hire your child under age 18, their wages are not subject to FICA taxes. Federal income and employment taxes, as well as some state taxes, still apply to wages paid to family members.
Establish an Employer-Sponsored Retirement Plan for Tax (and Nontax) Reasons
As a self-employed individual, you need to manage your retirement needs. Establishing an employer-sponsored retirement plan offers tax and nontax benefits. Your business may receive an immediate federal income tax deduction for funding the plan, and you can contribute pretax dollars into a retirement account. Contributed funds and earnings are not subject to federal income tax until withdrawn. However, early withdrawals (before age 59½) are generally subject to a 10 percent penalty and ordinary income tax unless an exception applies. Alternatively, a 401(k) plan with Roth contributions allows for future tax-free distributions.
Consider the following types of retirement plans:
- Keogh plan
- Simplified Employee Pension (SEP)
- SIMPLE IRA
- SIMPLE 401(k)
- Individual (or “solo”) 401(k)
Choose a plan based on your specific circumstances and the complexity of the plan. If you have employees, you may need to provide coverage for them. You may qualify for a tax credit of up to $5,000 for establishing and administering a plan. Consult a tax professional or refer to IRS Publication 560 for more information.
Take Full Advantage of Business Deductions to Lower Taxable Income
Deductions lower your taxable income, so ensure your business utilizes all eligible deductions. You may deduct various business expenses, such as rent or home office expenses, office equipment, furniture, supplies, and utilities. Deductions must be ordinary (common and accepted in your trade or business) and necessary (appropriate and helpful for your trade or business). If expenses are partly for business and personal purposes, you can only deduct the business-related portion.
To lower your taxable income, consider these possibilities:
- Maximizing business deductions
- Timing expenses to increase deductions for the current year
- Reviewing your expense records for overlooked deductions
Tax planning is crucial for the self-employed to manage tax liabilities and take advantage of available tax benefits. Consult with a tax professional to ensure compliance and optimize your tax situation.