How Are Freelancers Taxed?

Photographer working in a studio

More and more people are seeking side gigs or going 100% freelance after losing their jobs or seeing work hours cut in the past year. However, it's important to understand how taxes work as a freelancer. Freelancers are taxed as self-employed people, even if they haven't established a formal business structure.

A 2019 study by freelance platform Upwork found that 57 million American adults freelanced, with the share of those freelancing full time rising from 17% in 2014 to 28% in 2019. Those numbers may climb further as a result of the coronavirus pandemic: In another survey, Upwork found that 47% of hiring managers were more likely to tap freelance talent in the future due to the pandemic.

If you're one of the millions of Americans who freelance at least part time, or if you're pondering freelance work, here's how you can make your tax situation less taxing.

Are You a Freelancer?

At the start of a freelancing journey, many people don't realize that the IRS typically views freelancers as self-employed business owners. The IRS generally considers you to be self-employed if you:

  • Do business as a sole proprietor or an independent contractor. A sole proprietor owns a business by himself or herself. Freelancers who are sole proprietors typically choose to work for one or many different clients; in fields including web development, writing and graphic design. An independent contractor is typically considered a temporary employee and may go through an agency to get clients. Independent contractors can include doctors, dentists and lawyers.
  • Belong to a business partnership. The IRS defines a partnership as two or more people who make contributions to a business, such as labor or money, and share in the profits and losses. Each partner is considered a self-employed person, not an employee. An example of a partnership is a law firm.
  • Work for yourself in a part-time capacity. For example, you might work full time as an engineer but own an electronics repair shop on the side. Or you could be a gig worker, such as a rideshare driver, a handyman, a tutor or a virtual assistant.

How Do Taxes Work if You're a Freelancer?

As a self-employed person, you generally must file an annual federal tax return and pay estimated federal taxes every quarter. The taxes you usually must pay are:

  • Self-employment tax: The self-employment tax is a Social Security and Medicare tax that primarily affects self-employed people. It's like the Social Security and Medicare taxes that employers withhold from the paychecks of most employees. If you see the words "self-employment tax," it refers only to Social Security and Medicare taxes and not any other taxes (such as income tax). For self-employed people, the Social Security tax rate for 2020 is 12.4% and the Medicare tax rate is 2.9%, for a total self-employment tax of 15.3%.
  • Income tax: The IRS requires you to file a federal income tax return if your annual net earnings from self-employment (income minus expenses) add up to at least $400.

When Do You Pay Freelance Taxes?

If you expect to owe at least $1,000 in taxes when you file your annual return, the IRS requires making quarterly estimated tax payments. These payments cover both your self-employment and income taxes. At the end of the year, if you wind up owing more than you paid on a quarterly basis, the IRS may slap you with a penalty. That penalty, reflected on your federal tax return, is tacked on to the amount you already owe or comes out of your tax refund.

As a freelancer, you're responsible for paying these taxes on your own. Unlike an employer does with paychecks, anyone who pays you as a freelancer does not deduct taxes from the amount of money you receive.

When you earn freelance income, you'll receive what's known as a 1099-MISC form from anyone who paid you more than $600 during each tax year. If the sum is less than $600, the person or organization that paid you isn't required to send a 1099. However, you still must report that income to the IRS. For instance, if a tech company paid you $500 for your writing work over the course of a year, you wouldn't have gotten a 1099 but you would need to report the income.

How to Avoid a Huge Freelance Tax Bill

Since an employer isn't withholding taxes, it's important to carefully track your tax obligations as a freelancer. Otherwise, you could face a bigger-than-expected tax bill. Here are five ways to avoid a nasty tax surprise if you earn freelance income.

  1. Monitor your quarterly tax payments. The IRS normally expects you to make estimated tax payments before each quarterly deadline. If you don't, you face penalties and interest charges for missing a deadline or skipping payments altogether. Waiting until the next quarterly deadline or lumping all of your payments together at the end of the year doesn't pass muster with the IRS. Use IRS Form-1040 ES to calculate and make estimated tax payments.
  2. Save for retirement. You can reap tax savings by contributing to a traditional IRA (individual retirement account) or Solo 401(k), or by setting up a SIMPLE IRA or SEP IRA for your freelance business.
  3. Open a health savings account. A health savings account (HSA) coupled with a high-deductible health insurance plan can lower your tax burden. HSA contributions are tax-deductible.
  4. Explore tax-saving options. Aside from tax deductions for HSA contributions, freelancers enjoy several tax-saving options. They include tax breaks for education expenses, business meals, business travel, use of your home or car for freelance work, purchases of office supplies and equipment, internet service and other utilities, and health insurance premiums.
  5. Consider hiring an accountant. A professional may be able to help lower your tax bill by identifying tax deductions that you weren't aware of. For instance, the federal tax reform package passed in 2017 added a 20% deduction on what's known as qualified business income. This deduction applies to many self-employed people, such as sole proprietors and partners, but not all self-employed people.

Rules About Tax Deductions

While tax deductions can ease the financial pain of freelancing, keep in mind that they come with wrinkles. For instance, to qualify for a home office deduction, you in most cases must regularly and exclusively use a certain part of your house (such as a spare bedroom converted into an office) for business. A spare room that you only occasionally use for freelance work likely won't pass the IRS' test. Also, you probably won't be able to count your entire home for tax purposes.

Furthermore, you might need to undertake the complicated task of itemizing your deductions and keep meticulous records to back up those itemized deductions. If you go the itemization route, you'll need to file a Schedule A form for personal write-offs and a Schedule C form for business write-offs.

What if you don't want to bother with itemizing your deductions? You can take a standard deduction. The IRS advises that you should itemize deductions if the total dollar amount you could deduct exceeds what you'd gain from a standard deduction, or if you can't use the standard deduction. For 2020, the standard deduction is $12,400 for single people or separate filers, $18,650 for heads of household and $24,800 for joint filers.

Getting Ready for Tax Time

The IRS offers these suggestions to help you prepare for filing your 2020 tax return by the April 15, 2021, deadline:

  • Mark January 15, 2021, on your calendar. This is the final deadline for making the last quarterly estimated tax payment for the 2020 tax year.
  • Start gathering paperwork. Get a headstart on organizing your tax records for the 2020 tax year.
  • Be aware of the recovery rebate credit. You may qualify for this credit if you didn't receive a pandemic stimulus check in 2020 or if the payments you received were for less than the full amount.
  • Consider filing electronically. If you're going to get a refund, file your return electronically and opt for direct deposit to receive your money faster.
  • Use the free tax-filing feature. If your income for 2020 is $72,000 or under, you can file your federal tax return at no cost through the IRS File Free Program.

The Bottom Line

Being a freelancer offers freedom and flexibility—but it also comes with responsibilities. Chief among those responsibilities is paying federal taxes on the self-employment income you earn. Be sure you stay on top of your self-employment taxes to avoid issues with the IRS—and to avoid paying potential interest and penalties on overdue taxes.

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