Warning: Think About Freelance Taxes Now
According to a USA Today article, 40% of Millennials plan to leave their full-time jobs within 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.
DO NOT WAIT UNTIL TAX SEASON!
Freelance Taxes A Different Ballgame
When you’re an employee, you hear about tax rates and see a difference between the gross and net figures on your paycheck. But someone else does the number-crunching and makes your tax payments.
And if you’re like a lot of employees, you may overpay taxes throughout the year and end up getting a refund.
Having a job and not needing to focus on those details can distort the reality of how big your 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 isn’t really yours.
In many cases, freelancers don’t think about that or they don’t realize what that they’re destined to face at tax time.
And when tax time finally comes, they get sticker shock, and in some cases, end up in debt.
Since nothing is being deducted from their freelance income, they’re accruing several tax bills throughout the year and aren’t paying anything toward them.
Just imagine the financial trouble you would be in if you ran your household that way for a year.
Freelance Taxes: What’s The Difference?
For starters, freelancers are responsible for self-employment tax.
When people hear that term, they often think it refers to income tax for freelancers.
It doesn’t.
Self-employment tax = Social security tax + Medicare tax
That’s it.
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 2021 tax year, the self-employment tax rate is 15.3%.
Of that, 12.4% is for Social Security, and for the 2021 tax year, it’s charged on the first $142,800 of your earnings.
The other 2.9% of the self-employment tax goes to Medicare and is charged on all of your earnings.
Once you hit a certain threshold, you have to pay an additional Medicare rate of 0.9%. The threshold varies based on filing status.
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 remaining 85 cents.
Then, some freelancers and creative entrepreneurs are also responsible for additional obligations, such as sales or use tax.
So, as you can see, a freelance dollar gets reduced to a pile of change real fast.
Avoid The Freelance Tax Trap
Granted, not all freelancers end up with tax bills. Some actually 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.
The same is true if you’re already a freelancer and you drastically increase your income or you lose the ability to claim a valuable deduction, like a child.
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.
Just 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.
