Self-employment represents a significant share of the U.S. labor market. Many choose to work full-time as a sole-proprietor while many others pursue it part time through side hustles as a supplement their Form W-2 income. No matter your time commitment, it behooves you to learn about the self-employment tax deductions useful for managing your tax bill.
Regardless of your employment situation, you must pay taxes on your earnings derived from your trade or practice. In order to minimize the taxes you owe, you will want to read more about these 9 self-employment tax deductions useful for optimizing your tax return.
As a note, these tips still apply after tax reform.
1. Defer Income and Accelerate Self-Employment Tax Deductions to Avoid Higher Tax Brackets
Take advantage of last-minute self-employment tax deductions before year end and defer income until next year.
When possible near year end, you can accelerate certain expenses to count as tax deductions in the current year. This pulls forward deductions you normally may have taken next year to depress your taxable income this year.
On the revenue side of the ledger, you can also attempt to defer any income until the next year. This has the same effect of depressing your taxable income in the current year.
Taking advantage of these levers could lower your taxable income from higher income tax brackets, resulting in a lower tax bill and the amount of taxes you owe.
To illustrate this method of how to claim tax deductions in the current year for an expense due next year, let’s look at an example. If you receive a vendor invoice and it isn’t due until the following year but it can be paid this year, you might consider paying it now if possible.
Doing so will give you more tax savings to by lowering your taxable income.
Likewise on the revenue deferral, you may also have completed a contracted task for a client before year-end and can expect to receive payment before the year finishes.
In this case, assuming you can afford to do so, you might try delaying the invoice submission for payment until the beginning of the new year.
By using this tactic, you can defer income received this year and once again face a lower tax bill. This could push your income below a higher marginal income tax bracket and have you pay less tax on that dollar of income.
However, I urge caution when taking advantage of either approach. You should be mindful of how these decisions impact your estimated tax payments.
If this affects how much you pay in estimated tax payments and would result in adverse tax consequences or penalties, it might not make sense to pursue this strategy. This is especially the case if it does not make a significant difference in the end.
Weigh the costs and benefits and see if it makes sense to pursue this effort. In other words, be sure to look at your own personal situation and/or consult a tax professional to assess if this strategy makes sense for your unique circumstances.
If you find this to be an advantageous strategy and you are on the borderline of paying more in a higher income tax bracket, your year-end strategy should focus on bunching your deductions and income.
This means you should time your expenses and revenues to produce lean and fat years intermittently.
If you can control your timing, you should fit as many deductible expenses as possible into the year and defer revenue if it puts part of your taxable income into a lower income tax bracket. This will result in more tax savings come tax time.
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2. Use the Self-Employment Tax Deduction
As a Form W-2 employee, your employer pays their equal portion of payroll taxes on wages or salaries paid to you. However, when you are self-employed and you are the employer, it is your responsibility to pay both portions.
Being self-employed comes with many benefits: being your own boss, setting your own work hours, and ultimately having the flexibility to grow your business how you want. But, as with most good things, there are also associated downsides.
In the case of self-employment, one major drawback is needing to pay more in taxes. Specifically, the employer portion of payroll taxes (Social Security and Medicare taxes), also called self-employment taxes.
Everyone who makes earned income (e.g., wages, salaries, bonuses, commissions, tips, long-term disability, and anything not otherwise specifically excluded) must pay these payroll taxes, unless you’ve learned how to pay zero tax on passive income and long-term capital gains.
When you’re the boss and are self-employed, you must pay not only the 7.65% (6.2% for Social Security up to $128,400 in 2018 earnings and $132,900 in 2019; 1.45% for Medicare), but the other half as well (15.3% total).
Because if there weren’t enough taxes individuals face, you can’t forget an additional Medicare tax of 0.9%. This rate applies if you make more than $200,000 as a single tax payer or $250,000 as a married, filing jointly tax payer.
Be mindful of the fact the income thresholds for the additional Medicare tax apply not only to self-employment income, but also must take into account other wages and compensation.
For example, if you file as married filing jointly and you make $140,000 in self-employment income while your spouse makes a $120,000 salary, you’ll pay the additional Medicare tax on the $10,000 excess, amounting to $90.
Fortunately, the IRS understands this burden on self-employed individuals and offers a slight tax break with self-employment taxes. The IRS allows you to deduct the employer portion of the taxes from your taxable income, which results in you paying less than the full 15.3%.
In effect, you pay self-employment tax on 92.35% of your net business income, not gross income. This slight assistance can help offset some of the costs of running your business.
3. Contribute to an Individual Retirement Plan (IRA)
Tax-advantaged retirement accounts can lower your taxable income and grow funds in a tax-efficient manner.
One of the best ways to lower your taxable income is to make contributions to your retirement accounts. Because you are self-employed, you will not have access to an employer-sponsored 401(k) plan as your Form W-2 counterparts do.
However, there are other options available to you to save for retirement in a tax-efficient manner. For the self-employed, the most common method is through the use of an individual retirement account (IRA).
These accounts contain assets which follow you wherever you go and are not tied to one particular employer. This flexibility makes them valuable accounts in which to hold retirement assets.
There are two types of IRA accounts: Roth IRAs and Traditional IRAs.
The former places after-tax funds in your account and all gains are tax-free. The latter places before-tax funds into an account and does not require you to pay taxes on these funds until they are taken out of the account at retirement (or after 59 ½, whichever comes first).
Some other investment options available to you are Sep-IRAs, SIMPLE IRAs and solo 401(k)s. These tax-advantaged investments also allow you to reduce your tax bill now and grow your tax-deferred investments for later benefit.
The limiting factor on these accounts is the need to have earned income. Meaning, age requirements don’t factor into your eligibility to contribute to these retirement accounts.
Because of this, children with earned income from summer jobs or other employment can actually contribute to custodial Roth IRAs for kids.
4. Contribute to a Health Savings Account (HSA)
If you use a qualifying high deductible health plan to cover yourself or your family, you will have access to this triple tax-advantaged account.
If you haven’t heard the term before, you might ask yourself, “What is an HSA?” Health savings accounts (HSAs) are accounts offered to individuals who meet certain health insurance plan criteria, namely high deductible health plans with specific deductible thresholds.
Funds contributed to HSAs enjoy a triple tax-advantaged benefit. First, no taxes are paid on contributions made to the health savings account; second, no taxes are made on withdrawals for HSA eligible expenses; and third, no taxes are paid on gains realized from funds held in the account.
Many health savings accounts offer the holder the ability to invest in certain assets with their account contributions. If the holder is capable of not using the funds in the account, the funds can compound over time and accumulate a lot of value down the road.
A financial independence strategy my wife and I use is “cash flowing our HSA”. We avoid paying for healthcare costs from my HSA and use our regular cash flow to cover expenses.
Because these accounts are useful for investing in index funds, we allow those funds to compound over time.
5. Take Advantage of Educational Tax Credits
These credits can be useful for enhancing your hard skills and growing your business while lowering the amount of taxes you owe.
Have you been looking into growing your skill set as a means to enhance your business? Would taking a relevant class or earning a degree help further your business interests?
You might consider these options because doing so could earn you some valuable education tax credits.
- The American Opportunity Credit can save you up to $2,500 in taxes for the education expenses paid toward a degree to improve your competencies. To qualify, the student must pursue a degree at a school which is eligible to participate in the federal student aid program.This credit is only available to students in their first four years of attendance and they must be enrolled at least half time for one academic period during the tax year. This restriction makes it a less-likely candidate for a self-employed individual to use.
- The Lifetime Learning Credit is available to all taxpayers who attend at least one course during the year at an institution eligible to participate in the federal student aid program.This tax credit likely appeals to more self-employed individuals because they do not need to be enrolled in a degree or certification program in order to qualify. In fact, the student only needs to attend one course during the tax year.The credit covers the cost of tuition and fees plus any books and supplies required for the coursework when purchased directly from the school. The maximum benefit of the credit is $2,000 and is not refundable if it exceeds your tax bill for the year.
Also, you can look into whether you qualify for the earned income tax credit, which is a refundable credit for low- to moderate income workers. The credit has higher income thresholds and payouts if married and have children. One other credit to consider, which is non-refundable, is the solar energy investment tax credit if you purchased and installed any solar equipment on your property.
6. Home Office Tax Deduction
While the most complicated self-employment tax deduction on this list, this can be a major tax deduction to consider each year.
Tax reform in 2018 changed the treatment of home office expenses for W-2 employees (but not 1099 contractors) by removing their ability to deduct expenses against their taxable income. However, self-employed individuals retained this benefit and may still deduct qualified home office expenses from their taxable income.
Any expense a self-employed person pays related to a home office used regularly and exclusively for their business, regardless of whether the space is rented or owned, can count as a tax write off.
However, this is an area where you will need to be careful because it is at your discretion how you allocate these expenses if they are toward a space used for both personal and professional use.
In this situation, you operate under the honor system and as a result, you may need to be conservative with your claims. Anything egregious could draw the attention of the IRS.
As a tip when calculating the allocation of these expenses toward your home office expense, you can prepare a diagram which shows the work space relative to the size of the home. Be sure to use accurate measurements because the IRS will demand specifics if they push back on your claims.
Drawing this diagram will allow you to deduct the percentage this home office space represents of your home. Further, you will need to report the square feet to substantiate your home office tax deduction.
As an example, if your home is 3,000 square feet and your home office is 300 square feet, you may include 300/3,000 (10%) of the expenses as tax deductions.
The expenses you may deduct for your home office are:
- any expenses necessary to sustain your home office including the business percentage of deductible mortgage interest
- applicable home depreciation (check MACRS depreciation table)
- homeowner’s insurance
- home maintenance
- property taxes
Beginning in 2013, and continued under tax reform in 2018, there are two methods for calculating your home office deduction: the standard method and the simplified method. Unlike other elections in the tax code, you do not need to use the same method each year.
The standard method requires you to calculate your total home office expenses each year and use this amount as your tax deduction.
The simplified method allows you to multiply $5 per square foot of home used for your business with a maximum allowed amount of 300 square feet. This method might also be the better choice if you don’t have time to accumulate all of your qualified home office expenses.
However, these rates can vary by year depending on the IRS’s wishes and might not be as rewarding as the standard method. The decision is yours about whether you prefer one method to the other.
To know if you’re getting the biggest deduction, you will need to calculate your deductions using both methods.
Of note, the simplified option does not change the criteria for who may claim a home office tax deduction. Rather, it merely simplifies the calculation and record keeping requirements of the allowable deduction.
7. Utility Expenses Eligible for Self-Employment Tax Deductions
Utility expenses needed to sustain your business can be deducted from your taxable income.
Self-employment tax deductions also include expenses related to services needed to sustain your business. These expenses must be ordinary and necessary in order to qualify as self-employment tax deductions.
Items such as phone plans, utility bills (e.g., trash, water, electric and gas), and internet subscriptions all can be deducted for the portion used to run the business.
However, if these utility bills also serve your personal use, much like the home office tax deduction, you will need to use your best judgment on how much of each can be allocated to your business.
Some instances will be clear cut such as if you have a second cell phone plan solely dedicated to your business. In this case, you will be able to deduct 100% of that expense from your taxable income.
On the other hand, if you have a cell phone which is used for both business and personal use, you will need to identify the split between your use in each area.
8. Interest Paid on Business Loans
Interest expense paid on a loan taken out to fund your business qualifies as a self-employment tax deduction.
If you took out a business loan to fund operations, add capital to your business, or buy another business and filed Form 8594, you can deduct the associated interest expense from your taxable income. Sometimes the only way to grow a business is by financing the necessary investment with debt.
The interest expense associated with many types of debt can qualify for this tax deduction. While ill-advised if you can find other cheaper forms of funding, you may use a credit card to finance your business. You might consider a debit card if possible.
Though, the interest expense incurred for credit card debt may be deducted against your taxable income.
On the other end of the spectrum, you might find yourself taking on or offering a “below-market” loan. For lenders who provide funds at interest rates below-market, they may face imputed interest challenges.
For background, the federal government expects loans offered to charge at least a minimum level of interest. Otherwise these favorable terms could be seen as a way to dodge taxes on additional compensation, large gifts, dividends, or other taxable payments.
These minimums are set by the government and are called the Applicable Federal Rate, or AFR. Each month, the IRS publishes a list of current Applicable Federal Rates which reflect the current market interest rate environment.
If, for example, the current AFR is 2% on a 5-year loan and a lender extends a 5-year loan at no interest, or something below 2%, the lender will deal with imputed interest on the below-market loan.
The IRS assumes you collect interest at least at a rate commensurate with the AFR. If not, the IRS requires you to impute the costs in line with the AFR.
Imagine a scenario with an applicable 2% AFR and where your business loans $10,000 at 0.25% interest for 5-years to a friend or other business. Under your loan terms, the borrower would only pay you $25 per year in interest.
Under the AFR, you were expected to receive interest of $200 ($10,000 * 2%). The imputed interest you would need to pay tax on is $175 ($200 – $25). A rate below inflation isn’t likely to be offered in the market.
Be aware of this as you deal with lending or borrowing money and the implications you could face regarding market interest rates.
9. Self-Employment Health Insurance Deduction
If you meet certain criteria, you may deduct personal health insurance premiums as a self-employed person.
Healthcare is a cost of life in America. Fortunately, if you meet the criteria listed below, you may deduct the costs of your personal health insurance premiums.
- Your business claims a profit. If your business claims a loss on your tax return, you are ineligible for this deduction.
- If you are self-employed but are also an employee of another company with health insurance benefits, you cannot take a self-employment health insurance deduction. In order to deduct personal health insurance expenses, neither you nor your spouse may have insurance offered to you through another job.
- If you qualified to enroll in an employer’s plan only during part of the year, you can claim a tax deduction for premiums paid in the months you were ineligible for your employer’s health plan.
As a further note with respect to insurance, life insurance premiums generally cannot be deducted against your taxable income, even as a self-employed person or small business owner.
In some instances, you may have the ability to deduct life insurance premiums if you pay them as part of an employee benefit.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.