Most-Overlooked Tax Breaks and Deductions for the Self-Employed
Have you recently gone into business for yourself? Check out these seven ways to make the tax law work for you.
You're pursuing a dream? You're tired of your boss? You need more flexibility in your life? No matter what your reason is for quitting your old job and ventured out on your own, hanging out a shingle can be scary. The success of your business is in your hands when you're self-employed, so you need to take advantage of whatever assistance is available. That includes help lowering your tax bill.
Now that you've gone into business for yourself, check out these seven ways to make the tax laws work for you. You'll be happy you did when it's time to file your return.
Whether you are fully self-employed or do some freelancing in addition to your job as an employee, if you work at home the government might subsidize what are generally considered personal expenses.
The key to the home-office deduction is to use part of your home or apartment regularly and exclusively for your moneymaking endeavor. Pass that test and part of your utility bills and insurance costs can be deducted against your business income. You can also write off part of your rent or, if you own your home, depreciation (a noncash expense that can save you real money on your tax bill).
Many work-at-home taxpayers skip this break, either because they don't know about it, are afraid claiming it will trigger an audit, or are put off by the recordkeeping hassle necessary to back up the deduction if challenged. In recent years, though, the IRS has come up with a simplified method that allows taxpayers to deduct $5 for every square foot that qualifies for the deduction. If you have a 300-square-foot home office (the maximum size allowed for this method), your deduction is $1,500. You get this tax-saver every year you have a qualifying home office.
Business Use of a Vehicle
There's a tax deduction waiting if you drive your own car for business…and it isn't just for Uber or Lyft drivers. Any self-employed person who makes deliveries, drives to a client's location or otherwise uses a personal vehicle for work-related purposes can claim this deduction.
There are two ways to calculate the deduction – you can use the standard mileage rate or your actual car expenses. If you use the standard mileage rate, you can deduct 58¢ for every mile driven for business in 2019 (57.5¢ for 2020). Make sure you keep good records of the dates and miles you drive for work…and don't include driving for any personal trips or errands.
With the actual expense method, you add up all your car-related expenses for the year – gas, oil, tires, repairs, parking, tolls, insurance, registration, lease payments, depreciation, etc. – and multiply the total by the percentage of total miles driven that year for business reasons. For example, if your total annual car costs are $5,000 and 20% of your miles were for business, then your deduction is $1,000 ($5,000 x .2).
Health Insurance Premiums
Although medical expenses are deductible, relatively few taxpayers really get to deduct them. First, you have to itemize to get this break (and most taxpayers do not). Second, you get a deduction only to the extent your expenses exceed 7.5% of your adjusted gross income (10% beginning in 2021).
But there's a big exception for the self-employed. You can deduct what you pay for medical insurance for yourself and your family, whether or not you itemize and without regard to the 7.5% threshold. You don't qualify, though, if you are eligible for employer-sponsored health insurance through your job (if you have one in addition to your business) or your spouse's job.
Plus, if you continue to run your businesses after qualifying for Medicare, the premiums you pay for Medicare Part B and Part D, plus the cost of supplemental Medicare (medigap) policies or the cost of a Medicare Advantage plan, can be deducted as health insurance premiums without having to itemize.
Deduction for Qualified Business Income
There's a new tax deduction that debuted in 2018 that you may have heard about – it's called the qualified business income deduction (a.k.a., the Section 199A deduction). It's available for owners of S corporations, partnerships, LLCs and other "pass-through entities"…but did you know that self-employeds operating as sole proprietors can also claim it? It's a tricky tax break with several special rules and restrictions, but the write-off is sizable if you can jump through all the hoops.
Generally, eligible self-employed people can deduct up to 20% of qualified business income (QBI) from their business. QBI is the net amount of income, gain, deduction and loss from the business included in your taxable income (minus capital gains and losses, certain dividends, interest income, wage income and a few other items). However, the deduction is subject to various limitations if your 2019 taxable income is $321,400 for joint filers, $160,725 for married taxpayers filing separate returns, and $160,700 for single and head-of-household filers. (For 2020, the threshold is $326,600 for joint filers and $163,300 for all other taxpayers.) One of the limitations phases out the deduction for high earners running certain types of businesses (e.g., health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or, in limited circumstances, any business where the principal asset is the reputation or skill of its employees).
Again, it's a complicated deduction…but one well worth looking into if you're self-employed.
Social Security Taxes You Pay
Employees can't deduct the 7.65% of pay that's siphoned off for Social Security and Medicare. But if you're self-employed and have to pay the full 15.3% tax yourself (instead of splitting it 50/50 with an employer), you get to write off half of what you pay. Plus, you don't have to itemize to take advantage of this deduction.
Retirement Tax Shelters and Credits
Once you start working for yourself, the door opens wide to tax-sheltered retirement plans. Unlike employees, whose options are pretty much limited to whatever their employer offers and an IRA, self-employeds can contribute pretax money to a simplified employee pension (SEP) or a solo 401(k), both of which have higher annual limits than regular individual retirement accounts. (Oh, and you can still have an IRA, too.)
You may also get a tax credit for contributions to your retirement plan if your income isn't too high. It's called the Saver's Credit, and it can trim up to $1,000 off your tax bill ($2,000 for married couples). The credit is worth 50%, 20% or 10% of your contributions depending on your adjusted gross income. However, for the 2019 tax year, it's completely phased out for single filers with an AGI over $32,000 ($64,000 for joint filers). For 2020, the AGI threshold for singles is $32,500 ($65,000 for couples).
When you buy equipment for your business, you have two choices of how to share the cost with Uncle Sam.
The first is to depreciate the cost, deducting the expenses over the number of years the IRS figures is the "life" of the equipment. A computer has a life of five years, for example, so you can write off the cost over five years. But it's not as simple as claiming 20% of the cost each year. For that computer, for example, you'd deduct 20% of the cost in the year you put it into service, 32% in year two, 19.2% in year three, 11.52% in year four, 11.52% in year five and the final 5.76% in year six. (Don't ask why it takes six years to write off five-year property.)
Expensing (also known as the Section 179 deduction) lets you deduct 100% of the qualifying cost in year one. Is there any wonder why it's the choice of many self-employed taxpayers? For the 2019 tax year, up to $1.02 million worth of equipment is eligible for the immediate write-off of expensing ($1.04 million for 2020), although that amount is reduced if you place more than $2.55 million of new assets into service during any single year ($2.59 million for 2020).