There is a lot to love about self-employment. It can be enormously rewarding: offering independence to make your own choices, setting your own hours and of course, the thrill of building something on your own. But it also comes with some disadvantages. Taxes are for one.
Generally, self-employed workers must pay a self-employment tax: 15% for the first $132,900 of net income (2019) and an additional 2.9% on income above this level. In 1954, the Self-Employed Contributions Act (SECA) was passed to ensure that self-employed individuals would contribute to help fund Medicare and Social Security.
The good news is that when you’re working for yourself as a freelancer or a business owner rather than an employee, you have the ability to take far more deductions than a those who earn income only from salaries. The main goal of income tax planning is tax efficiency so that you end up minimizing federal tax liability as much as possible. There are three ways to end up owing little in taxes, and one of which is to reduce your taxable income.
How to Reduce Taxable Income
Your gross income is simply the sum of everything you earn in a year as an individual. This includes wages, capital gains, rental income, alimony, and even unemployment compensation. An adjusted gross income (AGI) is the amount left from your gross income after factoring in a number of allowable deductions or adjustments, including paid business expenses, student loan interest, and alimony.
Your AGI is the key element used to determine how much of your income is taxable. Basically, the higher the income and your AGI will be, the more taxes you’ll have to pay. Conversely, the less money you make, the fewer taxes you’ll have to pay. Here are popular ways to directly reduce your net income from self-employment legally:
Contribute as much to retirement plans
Among the biggest deductions that self-employed individuals can claim are their contributions to tax-advantaged retirement accounts, such as a 401(k) and IRA. These plans allow you to make a contribution that’s a fixed-dollar amount up to the limit, which is for the year 2019, $19,000 to a 401(k) and up to $6,000 to an IRA. Additionally, additional catch-up contributions of $6,000 to a 401(k) and $1,000 to an IRA are allowed for anyone over the age of 50. Before reaching the age of 59 years and six months, taking withdrawals from a 401(k) or IRA should be avoided as much as possible. The amount withdrawn will not only form part of your taxable income, but you’ll also end up paying a 10% tax penalty.
Deduct every business expense
Another big tax break for self-employed individuals is that they can qualify just about anything as an itemized deduction as long as they need it for business. For instance, the full purchase cost of a piece of equipment or machinery bought or financed after 2017 can be classified as a business expense. Travels are fully deductible, too. Additionally, if you’ve used part of your home for business, this is another place to look for deductions. The home office deduction allows the taxpayer to deduct expenses based on the part of the home exclusively or regularly used for the business. However, this deduction is also a red flag to the IRS as many self-employed individuals overvalue this deduction. Just make sure that you are always in compliance with the IRS rules.
With smart financial planning, you’ll be able to reduce your tax bill and keep more of your money working for you. Always make sure to consult a tax professional to avoid incorrectly claiming a business deduction.