Many people who leave jobs in mid-career choose to fly solo and start their own businesses, working out of their homes. Once you switch from life as an employee to become an independent contractor, your tax situation changes, too. Here are several things to keep in mind to keep your tax house in order:
Estimated tax payments. Your employer used to take care of withholding your income taxes and sending payments to the IRS. But once you're self-employed, it'll be up to you to make estimated tax payments to IRS during the year to cover your federal tax liability, unless you expect to owe less than $1,000. You make your payments quarterly, using Form 1040 ES.
Self-employment tax. To cover your Social Security and Medicare tax liability, in 2012 you'll owe Uncle Sam 13.3% on the first $110,100 of your net earnings from self-employment. For net earnings above $110,100 you'll still owe Medicare tax of 2.9%. The good news? You can deduct more than half of your self-employment tax when figuring adjusted gross income on your 1040. The deduction means the government effectively refunds a good chunk of the employer share of the Social Security tax you pay.
The Social Security tax rate for 2012 reflects the two percentage point payroll tax holiday in effect for both 2011 and 2012 the year. Before Congress okayed that tax-rate cut, self-employed taxpayers were permitted to deduct 50% of the Social Security tax they paid. For 2011 and 2012, the deduction is closer to 60%. Check the rules carefully to be sure you don’t shortchange yourself.
Business expenses. You can write off a long list of business costs -- everything from business meals to insurance to bad debts. It's important to maintain good records of those expenses so you can get all the tax deductions to which you're entitled. And because you can't deduct personal expenses, you must be sure to keep your business expenses separate. An easy way to do this is to set up a separate bank account for your business and have a credit card used only for business purchases. For expenses incurred that combine business and personal use, you'll need to determine the portion allocated to business and take a deduction only for that portion.
Home office deduction. If you're working from home, deducting the costs associated with your home office can be a big tax saver, but the rules are tricky. To get the deduction, the law requires you to use your home office "exclusively and regularly" for your business. It must be an area in your home where you don't mix business with other activities.
For example, if the den in your home is used only as your office, you can take the write-off. But if your family also uses the den as a playroom or for watching TV, you don't qualify for the deduction. The office also has to be your principal place of business or a place you meet regularly with clients or patients.
You can qualify even if you spend most of your work time away from the office -- as, say, a self-employed plumber who spends most of his time working at clients' homes -- as long as you manage the business from the home office and have no other office. If you qualify for home-office deductions, the write-off will help pay for what otherwise would be considered personal expenses, such as part of the cost of heating and lighting and home insurance premiums. Some taxpayers fear that claiming home-office deductions is a "red flag" for a tax audit; but don’t worry about that. If you deserve them, claim them.
Retirement savings. Starting a retirement plan is another great tax saver. And once you're self-employed, your options go far beyond the individual retirement account. Check out SEP (Simplified Employee Pension), SIMPLE (Savings Incentive Match Plan), Keogh and individual 401(k) plans. All allow you to sock away money for retirement and take a tax deduction for those pay-ins.
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