Becoming a freelancer doesn’t just change the way you work; it also changes the way you manage your money. One area that requires special attention when you’re self-employed is your tax filing.
To be successful as a freelancer, you have to treat it like a business in terms of marketing yourself and how you treat clients. The same idea applies to your taxes, since you’re solely responsible for making sure the IRS receives the right information. When I first started freelancing, taxes was something I only paid vague attention to since I wasn’t earning that much to begin with. Over time, I learned more about how freelance taxes work and what follows are 10 rules every newbie needs to keep in mind.
1. You can’t count on clients to keep track of your income
When you’re working for a company as a paid employee, they’re responsible for tallying up your earnings for the year. These are reported, along with the amount of taxes you’ve paid, on your W-2. As a freelancer, you’re considered an independent contractor, which means you’ll be issued a 1099 at the end of the year.
If you’re relying solely on 1099s to tell you how much money you made, you’re taking a big risk. It’s always possible that a client could omit a payment or make a mistake in their calculations. If you file your taxes based on incorrect information, you could be in for a nasty surprise if the IRS determines that you actually owe more money. Keeping your own records is a smart move to avoid errors.
I use a basic spreadsheet to track my income throughout the year. Specifically, I make note of what the project was, which client it was for, the amount, the date it was invoiced and paid and my net earnings after any PayPal or bank fees are deducted. It’s a fairly simple system, but it’s proven effective. I once had a client send a 1099 that was short by several thousand dollars and thanks to my spreadsheet, I was able to pick up on the error right away.
2. The IRS will know if you don’t report it
Underreporting or omitting income on your tax return is a major no-no and it’s a mistake to think that the IRS won’t catch on. For one thing, when a client mails you a 1099, they also send a copy to Uncle Sam so if you leave one out at tax time, your records aren’t going to match up with what the IRS already has on file.
Even if you’ve got a client who’s less than diligent in their record keeping, that doesn’t mean you should take a gamble on not reporting your income. One year, I had two different clients who never issued a 1099, even after I contacted them about it. It added up to a nice chunk of cash and while it was tempting to just forget about reporting it, I made sure it showed up on my return.
3. Keep business and personal accounts separate
If you’ve been freelancing for a while and you haven’t set up separate bank accounts for your business and personal spending, that should be at the top of your to-do list. For one thing, it simplifies your record keeping. You can easily see all of your income for the year and any expenses you incurred for the business without having to weed out what you spent on groceries or dinners out.
The other reason to split things up is to protect yourself in the event of an audit. If something on your taxes raises an eyebrow with the IRS, having separate bank statements for your business makes it easier to backup the information on your return.
4. You may have to pay estimated taxes
When you’re getting a regular paycheck, your employer is responsible for making sure that the appropriate amount of tax is withheld. As a freelancer, you may have to make estimated payments four times throughout the year, beginning in January. These payments are designed to cover your projected tax liability so you don’t end up with a big bill when April 15th rolls around.
Generally, you’re not required to make estimated payments if you didn’t owe any taxes during the previous year, you expect your total tax due for the current year to be less than $1,000 or your prior year’s federal withholding is equal to 90 percent of what you think you’ll owe. Be aware that if you don’t make estimated payments through the year and you end up owing taxes when you file, you could get hit with a penalty for underpayment.
5. Your tax liability is calculated differently
Freelancers are responsible for paying income tax but you’re also on the hook for self-employment tax. This is an additional tax that’s designed to cover the Social Security and Medicare amounts that would normally be withheld by a traditional employer. For the 2015 tax year, the self-employment tax rate is 15.3 percent for up to $118,500 in income. The most you’ll have to pay in self-employment taxes for the year is $14,694. That’s on top of whatever you’ll owe at your regular income tax rate.
6. Be clear about what you can deduct
The IRS has very clear rules on what you can and can’t include as a deduction on your taxes. Calling the corner of the living room where your laptop is located a home office probably isn’t going to cut it.
Generally, in order for something to be considered a deductible business expense it must be both reasonable and necessary. This can apply to things like a new laptop, business cards or travel expenses as long as they’re incurred as a direct result of your freelance work. If you’re in doubt about whether some qualifies, your best bet is to get advice from a tax expert or just leave it out altogether.
7. Keep appropriate records
Any time you plan to deduct something on your taxes, you’ll need a receipt or other documentation to back it up and that’s especially true when you’re running a freelancing business. Collecting all your receipts in a shoebox is a way to keep your physical receipts in one place, but using a program like Quickbooks cuts down on the clutter.
The software has a lot of features that are appealing to freelancers, including the ability to sync it with your bank account, track your expenses, create customized invoices and pay your bills. The most basic version costs $13.99 a month but if you don’t have the extra cash to spend, you can still keep tabs on what you’re spending with a free app like Expensify.
8. Your audit risk may increase
The words “tax audit” are enough to send a shiver down anyone’s spine and while they typically only affect a small percentage of the population, freelancers may be more susceptible. Statistically, filing a Schedule C on your taxes makes you two to four times more likely to get hit with an audit. The odds of being targeted increase by how much money you make so that’s something to keep in mind as you expand your freelance business.
9. Don’t overlook your retirement options
Being self-employed has lots of perks but unfortunately, a retirement plan isn’t one of them. Fortunately, there are several options out there that can help you build your nest egg while earning you some tax benefits.
For example, as a member of the Freelancer’s Union, I’m eligible to participate in a solo 401(k), which offers higher annual contribution limits than a traditional or Roth IRA, along with the ability to deduct the money that goes in from my income. There’s technically no employer match but I can chip in cash as an employer and an employee to the tune of $53,000 in 2015. Not only can I save for the future but I also score a tax break in the mean time by claiming the deduction.
10. Sometimes it’s worth it to hire a pro
Filing your taxes can be complicated enough when you’re dealing with W-2s and the standard deductions. When you throw in business expenses, estimated payments and self-employment tax, it can be even more challenging. If your freelance business has really taken off or you haven’t been keeping the best records so far, paying a tax expert to handle things for you may be a wise investment.