According to a USA Today article, 40% of Millennials plan to leave their full-time jobs within the next five years to go independent.
Anyone, millennial or otherwise, who plans to leave a job to freelance or become a creative entrepreneur, I urge you to go into it fully informed about the difference it will make for your taxes.
DON’T WAIT UNTIL TAX SEASON!
Freelance Taxes A Different Ballgame
When you’re an employee, you hear about tax rates and you see the difference between the gross and net figures on your paycheck but there’s someone doing the number-crunching and the paying for you, so you’re not really focused on the details.
And since a lot of people overpay taxes through their employer and end up getting a refund, it distorts the reality of how big their tax burden really is.
When you’re a freelancer, it seems all good when that money is rolling in untouched and you get every cent of every dollar. But all of that money really isn’t yours. In many cases, what happens is freelancers either aren’t thinking about that or they don’t realize what that they’re destined to face at tax time.
And when tax time comes, they get sticker shock, and in some cases, end up in debt.
Since nothing is being deducted from your freelance income, you’re accruing several bills throughout the year without paying on any of them. Just imagine the financial trouble you would be in if you ran your household that way for a year.
For starters, freelancers are responsible for self-employment tax. When people hear that term, they often think it refers income tax for freelancers.
Self-employment tax = Social security tax + Medicare tax
Social security and Medicare are things that an employer pre-pays before you touch your check. When you are your employer, you have to pay them yourself. And you have to pay self-employment tax regardless of your age, which means you pay it even if you’re currently collecting Social Security.
For the 2018 tax year, the self-employment tax freelancers are responsible for paying is 15.3%. (After $128,400, the rate drops to 2.9%.)
A good way to think about it is that self-employment tax will reduce every dollar a freelancer earns to about 85 cents.
On top of that, depending on factors such as location, exemptions, deductions and credits, freelancers may be responsible for federal, state, and local income taxes. Each one of those bills would subtract from that 85 cents.
Then, there are cases where freelancers and creative entrepreneurs are also responsible for items such as sales or use tax.
Granted, not all freelancers end up with tax bills. Some get refunds. But if you switch from being an employee to being self-employed, and you don’t know what to expect, there’s a risk that you may owe more than you can afford to pay at the end of the tax year.
That’s why one of the biggest tax mistakes freelancers make is not paying estimated taxes.
Estimated tax is a system where you make a payment to the IRS and/or your state tax department on a quarterly basis. If you think you’re going to owe tax, it’s a smart way to go. But remember, making a payment to one isn’t covering your obligation to the other.
Visit the IRS here and visit your state tax authority’s website to help determine if you need to pay quarterly, and if so, when and how much.