Ah, America’s favorite season is finally here. Luckily for all of us, tax filing season begins on January 24th this year, so it’s time to prepare ourselves. Well, this year is a little different for many, as the so-called “great resignation” has fueled a large number of people to become self-employed for the first time. In our article we will be discussing Self Employment Taxes Vs. Regular Income Taxes.
While self-employment comes with so many benefits, it can be confusing around tax time, but we have you covered. Let’s talk about the different types of taxes and some great tax tips for self-employed individuals!
Who Is Considered Self-Employed?
Before we offer any tips, let’s clear up any confusion around self-employed people and regular employees.
Generally, people will know if they are an employee or if they are self-employed. However, there are some gray areas and points of confusion for some around whether you are considered an employee or an independent contractor (self-employed person).
Independent contractors make up over 10 million workers in the US, and they may work solely for one company but still not be considered an employee.
For example, Uber/Lyft drivers, people who deliver for DoorDash/GrubHub, and most freelancers are considered independent contractors, even if they work for one company.
However, anybody can be an independent contractor or freelancer. Writing services, consulting, or plumbing are perfect examples of people who follow this structure, even though some are employees.
The way to determine this is if you receive a W2 form or a 1099 form at tax time. A W2 means that you are an employee who has taxes taken out with every paycheck. Most often, you will receive a tax refund for the previous year.
Conversely, a 1099 form like a 1099-K, 1099-misc, or another type, will be provided to you by any company that paid you more than $600 in the previous fiscal year. This means that you will likely owe taxes from that fiscal year, assuming that was your primary source of income.
Of course, a full-time Uber or Lyft driver will earn more than $600 in a year, leaving them with a 1099 form to file. Although, a freelance welder who had over 300 clients in the previous year and never earned more than $600 from any of them will not receive this form. Therefore, they will be responsible for filing this income from their own records.
Business owners are the obvious choice to file self-employment taxes, but not all of them will. First, an important distinction to make is that independent contractors (including DoorDash delivery people) are small business owners. However, in this instance, we’re using “business owners” in the way it is most commonly used.
Again, not all business owners will pay self-employment taxes for their income, but they will still have to file self-employment taxes. For example, some business owners choose to pay themselves a salary out of the company’s payroll so they can pay income taxes throughout the year as regular employees.
Regardless, they will still have to file self-employment tax for their business revenue and expenses, but they will not have to include their personal income in this instance.
Although, most small business owners, especially sole proprietors, choose to mix business and personal funds, meaning they will only file self-employment taxes.
How Do Income Taxes Differ?
While the tax rates are the same for personal income, the structure is completely different. If you file a W2 as an employee, that’s essentially all you will have to file, assuming that job was your only source of income.
Now, there are other potential deductions for an employee if you have to relocate for work, use home office space, or if you have dependents you support. However, generally speaking, filing W2s is a much simpler process.
With a 1099 or other self-employment tax type, you will have to file your business revenue and expenses, along with any relevant deductions. No matter if you are an independent contractor or small business owner, it is considered business revenue when filing self-employment taxes.
In this case, you will need to add all business-related expenses and subtract them from your gross revenue. Let’s say you are a self-employed plumber who made $70,000 in revenue this year. If you only file that, you will pay around a 30% tax rate on $70,000.
However, if you find that after mileage deductions, tools, supplies, van repairs, insurance, retirement savings, and other deductions, you netted $40,000, then you will only be paying taxes on the $40,000.
Conversely, if a plumber is considered a W2 employee and earns $70,000, they will have paid their taxes on the $70,000 throughout the year without all of the same deductions. If they paid more than what they owed, they will receive a tax refund.
Essentially, it is the responsibility of a self-employed person to track revenue and expenses throughout the year and report it honestly at tax time. For W2 employees, this is done for them throughout the year.
Six Helpful Self-Employment Tax Tips
Now that you understand some of the key differences between employee and self-employment taxes, you’re probably looking for some tax advice. Well, here it is!
1. Develop A Tracking System
If you’re used to the normal W2 structure, switching to self-employment taxes comes with a large learning curve. When you’re entirely responsible for tracking your income and expenses, you need to develop a proper system that you will use throughout the year.
Consequently, it doesn’t matter if you keep receipts in a filing cabinet, use an app on your phone, keep bank/credit card statements, or write out expenses on paper. Whatever works for you is what’s best, as long as you are keeping an accurate record of your revenue and expenses.
Of course, some businesses choose to hire a bookkeeper or accountant to handle this, but that isn’t feasible for most independent contractors. Either way, find a system that works for you and stick with it!
2. Understand Important Deductions
If you aren’t using all of the deductions to your advantage, then you are likely overpaying by a lot. Retirement, health plans, and other deductions are often overlooked for self-employed tax filers, but there are plenty of other tax credits. Some of the most commonly overlooked deductions include:
- Out-of-pocket charitable donations
- Dividend reinvestment
- Child and dependent care
- State sales taxes
- Moving expenses
- Student loan interest
- Vehicle costs
- Retirement plans
- Home office deduction
Also, it’s critical to know what counts as business expenses, as it could save you a small fortune. Of course, when you purchase something specifically for your business, it’s a business expense. However, there are plenty of other expenses you may also use in your personal life that may count.
For example, Uber drivers use their phones, the internet, and vehicles in their personal lives. However, they are essential for them to perform their work. Therefore, their phone bill, car insurance, maintenance, mileage (business mileage), and other relevant expenses can be deducted.
3. Don’t Mix Business And Personal
Now, if you’re an Uber driver, this may not apply to you. However, if your business requires a lot of frequent but irregular expenses beyond just gas and oil changes, it’s usually best to have a company credit card or bank account for business purchases.
Doing this will only make it easier to track business expenses and keep them separate from personal ones. For example, if you’re shopping at a department store for clothes and home goods but also grab some equipment for your car (business-related), you will need to separate the business purchases on your receipt or statement for proper tracking.
However, if you only use your company credit card for business expenses, you will only have to look at the statement to see how much money you spent on business-related purchases.
4. Know Your Rights
Contrary to popular belief, tax season doesn’t have to be too complicated or stressful. A major stressor for self-employed people, especially new ones, is wondering whether or not they have enough money to pay for their tax bills.
Assuming you understand all of your deductions and you’ve tracked your expenses diligently, then you should know how to file an extension. In some cases, it’s appropriate to file an extension to allow you to save money, and it won’t cost you a dime.
However, if you don’t file an extension and you miss the due date, you will receive a late fee of up to five percent of your total tax owed, and it will only get worse the longer you wait. It just has to be done before the tax deadline.
5. Don’t Wait Until The Last Minute
Waiting until the last minute guarantees you will be unprepared to file your taxes. Give yourself as much time as possible to prepare for the worst if you need extra time to save for the bill.
If you start filing at the end of January and discover you owe more than you anticipated, you will still have two and a half months to prepare for the bill. Consequently, if you wait until April, your extension may not be filed in time, which will come with unwanted fees.
6. Get Help Filing
Especially if it’s your first time filing, there’s a lot to know if you want to get it right. Spending a little on tax services could save you a lot on taxes.
With professional tax services, you can rest assured that you aren’t overpaying, have access to expert tax advice, and make doing taxes even easier than it was as an employee. All you’ll need is your financial records and they will cover the rest!
Frequently Asked Questions
Okay, now that we’ve offered some important tax advice, let’s briefly clear up any lingering questions you may have that we didn’t discuss. If you have further questions, keep reading our blog or talk to an accountant for more information.
Can I Determine My Tax Bill Before Tax Season?
Yes, you don’t have to wait until you file your taxes before finding out how much you owe. You can get an estimate by speaking to a tax specialist, accountant, or by using a self-employment tax calculator.
What If I’m An Independent Contractor And Employee?
In many cases, you may work for a company as a W2 employee and have a side business or transition from one to the other within the year. You will simply file both your W2 and self-employment taxes simultaneously.
As a pro tip, if you do work a part-time job along with your side hustle or business venture, you can request to have extra taxes taken out from your W2 job to help save money at the end of the year! However, that’s entirely up to you.
What If My Deductions Bring My Income Below Zero?
Sometimes in business, expenses exceed revenue. In this case, they will be considered business losses, which will offer you significant tax reductions, and potentially a refund.
Is It Better To Be An Employee Or Contractor?
This is entirely dependent upon your own personal preferences. However, studies show that self-employed people tend to be happier, but that isn’t always the case. There are pros and cons for both, especially at tax time.
Although, if you are a small business owner, this is an important question to answer for yourself so you can determine whether to pay yourself a salary or pay the bill at the end of the year.
What About Quarterly Taxes?
We’ve mainly discussed tax time for the previous fiscal year so far. However, if you want to avoid a large bill each year and you don’t want to worry about saving up, you can file quarterly taxes every 3 months.
When you do this, you will only owe taxes for the last quarter of the year during the normal tax season. Some self-employed people prefer this method, some prefer salary, and others prefer one lump sum.
Prepare Yourself Today
Now that you know the difference between Self-Employment taxes vs Regular Income taxes, you can use them to your advantage and prevent overpaying this year and next! Stay up to date with our latest tax advice by Reading our Articles below.