Freelancers have full control over their tax situations, more so than those who work as employees. But independence can come at a cost. Freelancers face a heavier tax burden, and they have more record-keeping responsibilities than employees.
Some special tax circumstances apply to freelancers and other self-employed professionals. Tax planning for self-employed persons begins with understanding how you're taxed in the first place.
Independent Contractor vs. Employee
A freelance professional is an independent contractor. The IRS has this to say about the rules differentiating contractors from employees:
"You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed."
An employer might instruct you to report at 9 a.m. on Monday and prepare a certain report. As a freelancer, you might contractually agree to deliver that report on Monday, but when you actually do so is up to you.
Other rules exist for defining independent contractors as well, regarding how the worker is paid and whether they receive company benefits.
Taxes on Self-Employment Income
Independent contractors are taxed on their net self-employment income: their gross receipts less their tax-deductible business expenses. This net amount is then taxed twice: once for regular federal income tax and again for the self-employment tax.
This sounds ominous, but it's not quite as bad as it sounds. Freelancers pay the same federal income tax rates on their incomes as employees do. The self-employment tax is what takes an additional bite out of freelancers' earnings.
The self-employment tax comprises Medicare and Social Security taxes. You would pay half these taxes, and your employer would pay the other half, if you worked for an employer. But freelance professionals are their own bosses, so they must pay both halves of these taxes themselves in the form of the self-employment tax.
Self-Employment Tax Rates and Thresholds
The self-employment tax functions pretty much like a flat tax. One size fits all—everyone pays the same percentage to Medicare and Social Security. But the Social Security tax applies only to earnings up to $137,700 in 2020 and $142,800 in 2021.
The Social Security tax is 12.4% of net income up to the threshold or "wage base," and the Medicare tax is 2.9% of total net income. Freelance professionals pay these full percentages. Employees pay 6.2% and 1.45%, respectively, and their employers pay those same amounts.
Preparing and Filing Schedule SE
The IRS has a form for calculating the self-employment tax—Schedule SE, which you must submit with your Form 1040 tax return.
If there's any good news here, it's that you can claim an above-the-line deduction for one half of your self-employment tax liability on Schedule 1 of your Form 1040. But you must still enter the total self-employment tax you calculated on Schedule SE on Schedule 2 of your 1040.
Preparing and Filing Schedule C
You can arrive at your net income by completing Schedule C with your Form 1040. This form is the "Profit or Loss From Business (Sole Proprietor)," and you must submit it with your tax return as well. You're a sole proprietor if you're not an employee and haven't taken legal steps to set your business up in some other form, such as a corporation.
Schedule C has five parts. Total up your all freelance income in Part I. Do not include any income you might have earned that was reported on a W-2. This is employee income and is taxed separately on your Form 1040.
Many contractors freelance in addition to holding down a regular job. Schedule C pertains only to income received for services performed as an independent contractor.
You can now add up and deduct your business expenses from your total income in Part II. Parts III through V deal with some unique expenses that you might or might not have, such as inventory or auto expenses.
After completing your Schedule C, you will have your net self-employment income figure. You will enter that number on Schedule SE, Schedule 1, and your Form 1040.
Estimated Tax Payments
Your employer would withhold income tax, Social Security tax, and Medicare tax from your pay each pay period and submit that money to the federal government on your behalf, along with its own contribution toward your Social Security and Medicare. But again, sole proprietors are their own bosses, so they must take care of all this themselves.
The Internal Revenue Service prefers that you do so on a pay-as-you-go basis. Freelancers should send in tax payments throughout the year by remitting estimated taxes. This can help prevent a cash crunch in April, at least if you estimate correctly, because all final tax payments are due by the April 15 tax deadline most years.
Estimated taxes are due quarterly. The due dates for tax year 2021 are April 15, June 15, September 15, and January 15, 2022. It's important to plan for and budget these tax payments.
The IRS extended the usual April 15 tax filing and payment deadline to May 17, 2021, because of circumstances related to the pandemic. Taxpayers in Texas, Oklahoma, and Louisiana have until June 15, 2021, because of a winter storm disaster area declaration.
Business expense deductions obviously play a significant role in helping freelancers keep their federal taxes under control. The more legitimate, qualifying expenses you have, the less your taxable income will be.
That ream of paper you bought last week for your office is tax deductible. Get in the habit of saving all your receipts, whether in paper form or with a smartphone app. It should be a knee-jerk reaction every time you spend money. Save credit card and bank statements, too.
Sit down with everything once a week while all those purchases and payments are still fresh in your memory. Sort them out. Which were business expenses? Which were personal?
Schedule C includes lines for some of the most common deductions to guide you so you don't miss any, and you can deduct others as well, even if they don't appear there, as long as they're "ordinary and necessary." This means that most others in your line of work claim the same expenses you do and that you could not produce income without spending money on them—or at least you wouldn't earn as much money if you didn't.
A typical tax planning strategy for freelancers begins by keeping track of income and expenses as the year progresses, then calculating estimated taxes. Then you can fine-tune your tax planning, perhaps by investing in a retirement plan or optimizing your depreciation methods. You can send the IRS what you anticipate you'll owe at year's end.
You can make tax payments more often than each quarter. Some freelancers have found that it can be easier on their budgets to send estimated payments to the IRS monthly, and this is perfectly OK.
After you calculate how much you'll owe quarterly, divide that number by three, and remit that amount each month. It can be easier to pay $400 a month rather than $1,200 quarterly if your income is relatively regular and doesn't fluctuate too much from month to month.
You might also get into the habit of withholding a percentage for taxes from each payment you receive as a sole proprietor and segregating that money in a separate account until you're ready to pay the government.