Being your own boss can be great. But when you’re self-employed, you also become your own human resources representative, office manager, and accountant. The finances can get complicated—especially come tax time! A little preparation will set you up for financial success.
Not sure whether you count as self-employed? According to the IRS, you’re self-employed if you meet any of the following conditions:
- You’re the sole proprietor of a business, meaning you run an unincorporated business on your own.
- You’re in a partnership that conducts business, such as an LLC.
- You operate your own part-time business whether or not the business makes a profit. The IRS considers any activity with a “profit motive” a part-time business, as long as you’re working to further the interests of the business by purchasing supplies or seeking customers.
- You’re an independent contractor. What’s a contractor exactly? An independent contractor is defined as someone whose client or payer can only control the results of the work, not what work will be done and how. Accountants, lawyers, doctors, dentists, and veterinarians are examples.
- You’re a freelancer. If you get 1099 tax forms in the mail from your employer, rather than the W2 wage-earning form, you’re considered self-employed.
Read on to learn about five crucial areas for the self-employed to navigate, and some tips to master each one.
You might have heard self-employment described as “feast or famine.” Sometimes business is booming and sometimes it slows to a crawl. Without an employer guaranteeing a consistent paycheck, how do you stay on top of your finances?
Start by setting aside a reserve or emergency fund. The idea is to have resources you can draw on if business is slow. Work towards eventually saving six months’ worth of living costs. Here are two possible ways to fill the fund:
- You can calculate your average monthly expenses. Then whenever your income exceeds these expenses, save the surplus in the reserve fund.
- Or you can save by adding a percentage of every paycheck, rather than a fixed dollar amount, to ongoing funds. These funds could include retirement accounts, student loans, taxes, or savings for big purchases. When you earn more, you contribute more. When you earn less, you contribute less. This is a smart way to live on a fluctuating income while still adding to cash reserves.
If your business is predictable–you know when the slow seasons and the busy seasons will be ahead of time–you can plan further down the line. Save extra funds in short-term CDs or interest-bearing checking or savings accounts. Don’t withdraw the money until you know you’ll need it. Short-term CDs may have penalties for early withdrawal. These accounts are a good option if you won’t need the cash for at least a few months.
2. Budget and manage cash flow
Do you have business expenses, such as equipment fees and employee salaries? Then it’s worth setting up a separate account exclusively for business. Not only will this make financial planning easier, it’ll help you figure out what tax deductions you can take.
Software to manage expenses, payments, and billing can be a lifesaver.
- Budgeting software gives you a straightforward picture of your cash flow.
- Invoicing apps manage invoices for multiple clients, keeping track of who’s paid up and who still owes you. Each client’s payment schedule may be different and you want all their information in one place. With a smaller number of clients, you can track invoices in Excel or a similar program without springing for the software. Consider switching to an invoicing app as your business grows.
- Payment processors are the easiest way to streamline payments from multiple sources. Paypal and Stripe are two of the most well-known processors, but there are plenty to choose from.
Two more tips to keep cash flow steady:
- Bill in installments. If possible, request deposits up front for long-term jobs, or periodic payments as work is completed.
- Vary your client base while building a solid network. One full-time freelancer I know advises not to let any client take up more than 30 percent of your time. This diverse network keeps you busy no matter what. While it’s essential to reach out, ideally you want to build several loyal, long-term client relationships. These relationships are most likely to be the heart of your business.
Consider working with an accountant to get a clearer long-term picture of your business needs. Accountants can be especially helpful for one of the trickiest and least fun parts of self-employment, which is…
3. Pay taxes
Self-employed workers, including freelancers and small business owners, don’t have taxes withheld from their paychecks. This means you’re in charge of figuring out how much you owe the IRS. And don’t wait for springtime. You should budget for—and pay—taxes all year.
As long as you earned $400 or more from self-employment, you’ll file a return. This applies whether you’re solely self-employed or you add a side business to a wage-earning job.
The amount and schedule of taxes came as a big surprise my first year of self-employment. I made a rookie freelance mistake: I didn’t set aside tax money.
The guidelines for self-employment taxes are different than for wage earners’ taxes. Keep these three rules of thumb in mind.
Stash away between 25 and 30 percent of your income for taxes all year round.
Seem high? The amount may be more than you need, depending on how many deductions you can take. But it’s better to be over prepared.
Figure out your estimated tax.
You’ll be paying two types of taxes:
Self-employment tax. When you are an employee you pay half your FICA taxes (Social Security and Medicare) and your employer pays the other half. However, when you are self-employed you have to cover both the employee and the employer portions.
These taxes total 15.3 percent.
- Social security is 12.4 percent on the first $147,000 earned annually
- Medicare is 2.9 percent on the first $200,000 earned annually. Then there is an additional 0.9 percent (3.8 percent total) on earnings above $200,000
Income tax on your business profits. This tax is based on your net income. To calculate your net income, take the total revenue you earned—this is your gross income—and subtract any business expenses and deductions. We’ll talk about which deductions you can take in the next section. If your business expenses end up exceeding your income, for instance, you can deduct a net loss for the year.
If this is your first year paying taxes on self-employment, estimate how much you think you’ll earn during the year. You can make adjustments later if the estimate ends up being too high or too low.
The IRS 1040-ES helps you calculate your estimated tax.
Since you aren’t having taxes taken out of your paycheck like an employee does you’ll need to periodically send in your income taxes during the year with quarterly tax payments.
This one is hard to adjust to. But once you get the hang of it, quarterly tax payment actually helps with cash flow. You pay as you go rather than handing over a lump sum in the spring. Plus, you’ll avoid any penalties for late payment.
Once you figure out your estimated tax—self-employment tax plus income tax—divide that number by four. This is the amount you’ll pay the IRS each quarter.
Check the Form 1040-ES for the payment dates. In general, they’ll be April 15, June 15, September 15, and January 15. The easiest way to pay is electronically at the IRS website. You can set up direct deposit for the due dates or figure out a monthly installment agreement if you can’t pay the full quarterly sum.
Miss a payment (or two)? You’ll get hit with a late fee, but there are ways to pay without interrupting your cash flow too severely.
4. Take tax deductions
This part makes the payments easier. And there’s some flexibility in what you can claim as a business expense.
First off, a business expense must be ordinary (something most people in your field use) and necessary for your line of work. You can only deduct the portion of an expense you actually use for business. For instance, if you have a car for both business and personal use, you can deduct mileage racked up on the job. This is where the separate business account and expense trackers come in handy.
Some of the most common self-employment deductions are:
The home office deduction
This one is complicated. You can’t always take a home office deduction even if you work from home.
To qualify, your home (or the area you work in) should be your regular and exclusive place of business. If you have a room or office you only use for business purposes, you can deduct it.
The home office also needs to be the principal or primary place of your business—your base. If you occasionally work or have meetings elsewhere, you can take the deduction as long as you use the home office consistently.
You can also deduct a percentage of your mortgage, property taxes, and home maintenance expenses. Deduct 10 percent of your utility bill, for instance, if your workspace occupies 10 percent of your home.
Since the calculations can get confusing, the IRS lets you take a simplified deduction. For this option you take accurate measurements of your work space. Then deduct five dollars per square foot for no more than 300 square feet. The maximum deduction is $1,500 using this method.
The simplified option doesn’t allow you to deduct home maintenance costs or depreciation, however. If your space is larger than 300 square feet or you want to take a depreciation deduction, use the standard option, not the simplified one.
It’s good to have space calculations on hand either way, since the home office deduction might flag you for an audit. Be prepared with measurements and a diagram in case the IRS asks.
Retirement savings, for you and for any employees.
Any contributions to individual retirement plans like SEP IRAs and solo 401(k)s are deductible.
Health insurance premiums
If you’re paying for a health or dental plan out of pocket. You can include yourself, a spouse, and any dependents if they’re on the same plan.
You can deduct half of the self-employment Social Security and Medicare tax. In other words, you’re deducting the half your employer would kick in if you were a wage earner.
If you have employees for your small business, you can deduct their paychecks.
Internet and phone bills
You can only deduct the portion or percentage of these services used for business.
Other deductions you might take, if your work requires travel and client meetings, include:
This only counts for business purposes. Use a mileage tracker if you drive frequently for work, so you’ll know how much to deduct.
Meals, entertainment, and travel expenses
The rules are pretty strict. You can only deduct 50 percent of meal and entertainment expenses. And you should prove you conducted business before, during, and after the event.
Similarly, a travel deduction should come with proof the trip was exclusively a business trip. Claiming these deductions raises the risk of an audit. Be prepared with records and receipts.
5. Plan for retirement
A retirement account is a smart, affordable investment even without an employer matching your contributions. There are two main types of retirement plans for the self-employed, and both are tax-deductible. They’re the Simplified Employee Pension IRA or SEP IRA, and the solo 401k. Which one’s the better choice? That depends mostly on your needs.
The SEP IRA
The SEP IRA works much like a traditional IRA or Individual Retirement Account. You contribute money to the account and get tax breaks as a result. You can open an SEP IRA with any amount of self-employment income, including a side business. And you can use an SEP IRA to supplement another retirement plan.
These accounts are easier to set up than 401(k)s and require less administrative maintenance.
How much can you contribute to an SEP IRA each year? It depends. If you’re a solo contractor or freelancer (your own employee) the tax-deductible contribution limits are the lesser of either:
25 percent of compensation, or an annual cap, which was $66,000 for 2023 and changes each year to adjust for cost of living.
The limits also apply if you have employees for your business and contribute to their SEP IRAs.
If you’re adding to your own SEP IRA account as a partner, proprietor, or employer in a small business, the IRS has special contribution guidelines.
Other things to know about SEP IRAs:
- You can open an SEP IRA up until April 15 to claim deductions for the prior tax year.
- You’re not required to contribute annually.
- There’s a 10 percent penalty if you withdraw funds before turning 59 ½.
- You can only contribute cash, not property.
- You can convert the account to a solo 401k in the future if you want.
- Unlike a traditional IRA, you can’t make Roth contributions.
- You can’t take out a loan from an SEP IRA.
The Solo 401k
The solo 401k is only available to sole proprietors—business owners, contractors, or freelancers without employees except themselves or a spouse.
This account allows higher contributions than the SEP IRA. As a bonus, you can contribute twice to a solo 401k, both as an employee and an employer. There are two types of contributions, and you can make both in a given year:
Elective deferrals. This is an annual capped amount, set at $22,500 for 2023 but subject to change based on cost of living. Once you turn 50 you can contribute more (the 50-and-over cap is $30,000 in 2023). This limit includes any contributions you make to another 401k—for instance, if you have a 401k from a day job but you’re self-employed on the side.
Employer nonelective contributions. As an employer you can save up to 25 percent of your annual compensation. If you also want to make a nonelective contribution as an employee, the IRS lets you contribute 20 percent of net income. Take your business’s profit and subtract your self-employment tax deduction and any 401k contributions you made as an employer. Your limit is 20 percent of this total.
Complicated, I know. The solo 401k is the more paperwork-heavy of the two plans. But it’s a good choice if you want to contribute as much as possible to a retirement account.
Other things to know about a solo 401k:
- You have until December 31 to open a solo 401k if you want tax breaks for the following April.
- You can make traditional or Roth contributions.
- Borrowing against your retirement plan is allowed via 401k loan (up to $50,000).
- You can set up the plan to enable early access to funds through hardship distributions.
- Once your plan assets exceed $250,000 you need to fill out IRS form 5500 annually.
- You pay taxes on any contributions and earnings you withdraw from the fund.
Getting your finances shipshape for solo entrepreneurship may take a while. But the more you plan, the easier the hard stuff like taxes and budgeting will become. Then you can concentrate on building a great business, or enhancing the business you already have.