Self-Employed Professionals Can Save Big on Taxes
By Joe Globensky, RFC®
Whether you have been a self-employed professional for years, or you’ve recently become self-employed, the success of your business is in your hands. You need to take advantage of whatever assistance is available, and this includes lowering your tax bill.
Here are some of the more popular and sometimes overlooked ways to cut down on your tax bill.
You might be surprised to learn that the way you organize your business can make a difference in your tax obligation. In some cases, you might be able to reduce your tax burden by organizing as an S corporation instead of a sole proprietorship or LLC. With an S-corp election, you can pay yourself a salary and potentially avoid self-employment taxes on a portion of it.
In other situations, it might make sense to organize as a C corporation, where the first portion of your money earned is taxed at a lower rate. This option isn’t great for everyone, and problems can arise if you aren’t careful.
The self-employment tax refers to the Medicare and Social Security taxes that every self-employed professional must pay. This includes freelancers, independent contractors, and small-business owners. The self-employment tax rate is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. An additional 0.9% Medicare tax rate applies if income is above a threshold amount.
Paying more to be your own boss is no fun, but there’s good news. You can deduct half of your self-employment tax as a business expense. It’s one of the most common self-employment tax deductions.
As a self-employed professional, you can lower your tax burden, and start your retirement planning, by contributing to a solo 401(k), or by setting up a SIMPLE or SEP-IRA for your business. These are great ways to reduce your taxes now while allowing you to save for your future retirement.
Contribution limits vary by plan type and the IRS adjusts the maximums annually. For the 2020 and 2021 tax years, you could feasibly contribute as much as $19,500 in deferred salary ($26,000 if you’re 50 or older). Plus, you may be able to contribute another 25% of your net self-employment earnings after deducting your self-employment tax and your salary deferrals.
Health Insurance Premiums
If you are self-employed, pay your own health insurance premiums, and are not eligible to participate in a plan through your spouse’s employer, you can deduct all your health, dental, and qualified long-term care insurance premiums.
You can also deduct premiums that you paid to provide coverage for your spouse, your dependents, and your children who are younger than 27 at year-end, even if they aren’t dependents on your taxes.
Health Reimbursement Arrangement
A Health Reimbursement Arrangement (HRA) is a plan set up by an employer to cover medical expenses for its employees. An HRA is funded solely through employer contributions and may not be funded through employee salary deferrals. Under IRS rules, employers have the option of allowing current and former employees to use HRA funds for expenses of a spouse and/or dependents.
That last point can be significant if you own your business, have a spouse that can be employed by your business, and you have children. Collectively, you may have high medical expenses that can be covered tax-free by an HRA. Without the HRA, these medical expenses can be itemized on your tax return, but you can only deduct expenses that exceed 7.5% of your adjusted gross income (AGI).
Many more people worked from home in 2020 than in previous years. If you did so as a self-employed professional, then the home office deduction may help you save money on taxes. While it is one of the more complex deductions, the cost of any workspace that you use regularly and exclusively for business can be deducted as a home office expense.
There are two ways to calculate the home office deduction, the standard method or the simplified option. The standard method requires you to calculate your actual home office expenses, including the business percentage of deductible mortgage interest, home depreciation, utilities, homeowner’s insurance, etc. For example, if your home office occupies 10% of your home, then 10% of your electricity bill becomes tax-deductible. But make sure you keep detailed records of all the expenses you are using for the home office deduction in case of an IRS audit.
The simplified option lets you multiply an IRS-determined rate by your home office square footage. The simplified option is the clear choice if you’re pressed for time or don’t keep good expense records. However, the simplified option is calculated at $5 per square foot with a 300 square foot maximum, so the most you’ll be able to deduct is $1,500.
Qualified Business Income
One of the newest self-employment tax deductions is the qualified business income deduction (QBI). Thank you, 2017 tax reform. The QBI deduction allows eligible self-employed and small-business owners to deduct a portion of their business income on their taxes.
The QBI deduction is for people who have “pass-through income.” That’s business income you report on your personal tax return. Entities eligible for the QBI deduction include sole proprietorships, partnerships, S corporations, and limited liability companies (LLCs). And there are some income limitations on this deduction so make sure you seek good counsel when doing your tax planning.
There are many other expense items that you can deduct as a business expense. These include start-up costs, internet and phone bills, business travel and meals, business insurance, rent, advertising, and office supplies, to name a few.
The big catch with taking business deductions is that you must be profitable. If your business consistently loses money, the IRS considers it a hobby, not a business. There are also some limitations to deductions for meals and other expenses. If in doubt, consult a tax professional.
The Bottom Line
Most small business tax deductions are more complicated than this brief overview describes. While you can’t completely eliminate what you owe in taxes, it’s possible to reduce your tax burden as a self-employed professional with the right strategy.
At Connections Financial Advisors, we educate small business owners and self-employed professionals through our planning process. We would welcome the opportunity to show you how a small business can benefit from having a financial advisor as part of their team. To schedule a free, no-obligation introductory meeting, reach out to us at (217) 605-8130 or firstname.lastname@example.org.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Connections Financial Advisors and LPL Financial do not provide tax advice.
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