What Is the Self-Employment Tax?

Working for yourself, either as a part-time side hustle or a full-time endeavor, can be very exciting and financially rewarding. But one downside to self-employment is that you're responsible for following special tax rules. Missing tax deadlines or paying the wrong amount can lead to expensive penalties.

Let's talk about what the self-employment or SE tax is and how it compares to payroll taxes for employees. You’ll learn who must pay the SE tax, how to pay it, and tips to stay compliant when you work for yourself.

What is the self-employment (SE) tax?

In addition to federal and applicable state income taxes, everyone must pay Social Security and Medicare taxes. These two social programs provide you with retirement benefits, disability benefits, survivor benefits, and Medicare health insurance benefits.

Many people don’t realize that when you’re a W-2 employee, your employer must pick up the tab for a portion of your taxes. Thanks to the Federal Insurance Contributions Act (FICA), employers are generally required to withhold Social Security and Medicare taxes from your paycheck and match the tax amounts you owe.

In other words, your employer pays half of your Social Security and Medicare taxes, and you pay the remaining half. Employees pay 100% of federal and state income taxes, which also get withheld from your wages and sent to the government.

When you have your own business, you’re typically responsible for paying the full amount of income taxes, including 100% of your Social Security and Medicare taxes.

But when you have your own business, you’re typically responsible for paying the full amount of income taxes, including 100% of your Social Security and Medicare taxes.

Who must pay the self-employment tax?

All business owners with "pass-through" income must pay the SE tax. That typically includes every business entity except C corporations (or LLCs that elect to get taxed as a corporation).

When you have a C corp or get taxed as a corporation, you work as an employee of your business. You're required to withhold all employment taxes (federal, state, Social Security, and Medicare) from your salary or wages. Other business entities allow income to pass directly to the owner(s), so it gets included in their personal tax returns.

You must pay the SE tax no matter if you call yourself a solopreneur, independent contractor, or freelancer—even if you're already receiving Social Security or Medicare benefits.

You must pay the SE tax no matter if you call yourself a solopreneur, independent contractor, or freelancer—even if you're already receiving Social Security or Medicare benefits.

How much is the self-employment tax?

For 2020, the SE tax rate is 15.3% of earnings from your business. That's a combined Social Security tax rate of 12.4 % and a Medicare tax rate of 2.9%.

For Social Security tax, you pay it on up to a maximum wage base of $137,700. You don't have to pay Social Security tax on any additional income above this threshold. However, this threshold has been increasing and is likely to continue creeping up in future years.

However, for Medicare, there is no wage base. All your income is subject to the 2.9% Medicare tax.

So, if you're self-employed with net income less than $137,700, you'd pay SE tax of 15.3% (12.4% Social Security plus 2.9% Medicare tax), plus ordinary income tax.

Remember that your future Social Security benefits get reduced if you don't claim all of your self-employment income.

What is the additional Medicare tax?

If you have a high income, you must pay an extra tax of 0.9%, known as the additional Medicare tax. This surtax went into effect in 2013 with the passage of the Affordable Care Act (ACA). It applies to wages and self-employment income over these amounts by tax filing status for 2020:

  • Single: $200,000 
  • Married filing jointly: $250,000 
  • Married filing separately: $125,000 
  • Head of household: $200,000 
  • Qualifying widow(er): $200,000

What are estimated taxes?

As I mentioned, when you’re an employee, your employer withholds money for various taxes from your paychecks and sends it to the government on your behalf. This pay-as-you-go system was created to make sure you pay all taxes owed by the end of the year.

You must make quarterly estimated tax payments if you expect to owe at least $1,000 in taxes, including the SE tax.

When you’re self-employed, you also have to keep up with taxes throughout the year. You must make quarterly estimated tax payments if you expect to owe at least $1,000 in taxes, including the SE tax.

Each payment should be one-fourth of the total you expect to owe. Estimated payments are generally due on:

  • April 15 (for the first quarter) 
  • June 15 (for the second quarter) 
  • September 15 (for the third quarter) 
  • January 15 (for the fourth quarter) of the following year

But when the due date falls on a weekend or holiday, it shifts to the next business day. Your state may also require estimated tax payments and may have different deadlines.

How to calculate estimated taxes

Figuring estimated payments can be extremely confusing when you’re self-employed because many entrepreneurs don’t have the faintest idea how much they’ll make from one week to the next, much less how much tax they can expect to pay. Nonetheless, you must make your best guesstimate.

If you earn more than you estimated, you can pay more on any remaining quarterly tax payments. If you earn less, you can reduce them or apply any overpayments to next year’s estimated payments.

If you (or your spouse, if you file taxes jointly) have a W-2 job in addition to self-employment income, you can increase your tax withholding from earnings at your job instead of making estimated payments. To do this, you or your spouse must file an updated Form W-4 with your employer.

The IRS has a Tax Withholding Estimator to help you calculate the right amount to withhold from your pay for your individual or joint taxes.

How to pay estimated taxes

To figure and pay your estimated taxes, use Form 1040-ES, Estimated Tax for Individuals, or Form 1120-W, Estimated Tax for Corporations. These forms contain blank vouchers you can use to mail in your payments, or you can submit funds electronically.

When you have a complicated situation, including having business income, one of your new best friends should be a tax accountant.

For much more information about running a small business successfully, check out my newest book, Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. Part four, Understanding Business Taxes, covers everything you need to know to comply and stay out of trouble.

From personal experience, I can tell you that when you have a complicated situation, including having business income, one of your new best friends should be a tax accountant. Find one who listens well and seems to understand the kind of work you're doing.

A good accountant will help you calculate your estimated quarterly taxes, claim tax deductions, and save you money by helping you take advantage of every tax benefit that's allowed when you're self-employed. In Money-Smart Solopreneur, I recommend various software, online services, and apps to help you track expenses, deductions, and tax deadlines that will keep your business running smoothly.

Continue reading

1099-C: What You Need to Know about the Cancellation of Debt Tax Form

From early January to mid-February, you might receive a number of tax documents in the mail. They can range from expected W-2s from your employer to forms about mortgage interest you paid. One form that many people don’t expect is the 1099-C. Discover why you would receive such a form and what the IRS expects… Read More

The post 1099-C: What You Need to Know about the Cancellation of Debt Tax Form appeared first on Credit.com.

Continue reading

5 Things to Know About the Home Office Tax Deduction and Coronavirus

Since the coronavirus quarantine began, many people have been forced to work from home. If you didn’t have a home office before the pandemic, you might have had a few expenses to set one up. I’ve received several questions about what benefits are allowed for home offices during the COVID-19 crisis.

One question came in on the QDT coronavirus question page. Money Girl reader Ian said:

"I have a question about next year's taxes and working from home. For the past 13 weeks, I have been forced to work from a home office. (I am a regular W-2 employee, not self-employed.) I have had some expenses come up that were brought about by working from home: a computer upgrade so I can better connect to Wi-Fi, a new router, and even a desk chair so I am comfortable while I work. Should I be keeping track of those expenses? Will they be deductible? My employer is not going to reimburse them. Thank you for your help!"

Another question came from Miki, who used my contact page at Lauradadams.com to reach me. She said:

"Hi, Laura, and thank you for a wonderful podcast! I've been listening for years and have always thought that you'd have a show for any question I could ever think of. But this new situation with COVID-19 has made me think of something that I'm sure many of us are dealing with right now.

"To start working from home, I had to spend quite a bit of money to get my home office on par with my actual office. I know you've done episodes on claiming home office expenses on taxes before, but could you do an episode on whether we can claim home office expenses on our taxes next year? And if we can, things we should start thinking about now (aside from saving the receipts)?"

Thanks for your kind words and thoughtful questions! I'll explain who qualifies for a home office tax deduction and serve up some tips for claiming it.

5 things to know about the home office tax deduction during coronavirus

Here's the detail on five things you should know about qualifying for the home office tax deduction in 2020.

1. COVID-19 has not changed the home office tax law

The CARES Act changed many personal finance rules—including specific tax deadlines, retirement distributions, and federal student loan payments—but the home office tax deduction is not one of them. In a previous post and podcast, Your Guide to Claiming a Legit Home Office Tax Deduction, I covered the fact that the Tax Cuts and Jobs Act (TCJA) of 2017 drastically changed who can claim this valuable deduction.

Before the TCJA, you could claim a home office deduction whether you worked for yourself or for an employer either full- or part-time. Unfortunately, W-2 employees can no longer take advantage of this tax benefit. Now, you must have self-employment income to qualify. My guess is that the IRS was concerned that it was too easy to abuse this benefit and reined it in.

Before the TCJA, you could claim a home office deduction whether you worked for yourself or for an employer either full- or part-time. Unfortunately, W-2 employees can no longer take advantage of this tax benefit.

The best option for an employee is to request expense reimbursement from your current or future employer even though they're not obligated to pay you. If you get pushback, make a list of all your home office expenses so it's clear how much you spent on their behalf. They might consider it for your next cost of living raise or bonus.

Unless Miki or Ian have a side business that they started or will start, before the end of 2020, they won't get deductions to help offset their home office setup costs.

 

2. The self-employed can claim a home office tax deduction

Let’s say you use a space in a home that you rent or own for business purposes in 2020. There are two pretty straightforward qualifications to qualify for the home office deduction:

  • Your home office space must be used regularly and exclusively for business
  • Your home office must be the principal place used for business

You could use a spare bedroom or a hallway nook to run your business. You don’t need walls to separate your office, but the space should be distinct—unless you qualify for an exemption, such as running a daycare. It’s permissible to use a separate structure, such as a garage or studio, as your home office if you use it regularly for business.

You must use your home as the primary place you conduct business—even if it’s just for administrative work, such as scheduling and bookkeeping. However, your home doesn’t have to be the only place you work in. For instance, you might work at a coffee shop or meet clients there from time to time and still be eligible for a home office tax deduction.

3. Your business can be full- or part-time to qualify for a home office tax deduction

If you work for yourself in any trade or business, either full- or part-time, and your primary office location is your home, you have a home business. No matter what you call yourself or your business, if you have self-employment income and do any portion of the work at home, you probably have an eligible home office. You might sell goods and services as a small business, freelancer, consultant, independent contractor, or gig worker.

If you work for yourself in any trade or business, either full- or part-time, and your primary office location is your home, you have a home business.

As I previously mentioned, the work you do at home could just be administrative tasks for your business, such as communication, scheduling, invoicing, and recordkeeping. Many types of solopreneurs and trades do most of their work away from home and still qualify for a legitimate home office deduction. These may include gig economy workers, sales reps, and those in the construction industry.

4. You can deduct direct home office expenses for your business

If you run a business from home, your direct home office expenses qualify for a tax deduction. These are costs to set up and maintain your office, such as furnishings, installing a phone line, or painting the walls. These costs are 100% deductible, no matter the size of the office.  

5. You can deduct indirect home office expenses for your business

Additionally, you’ll have costs that are related to your office that affect your entire home. For instance, if you’re a renter, the cost of rent, renters insurance, and utilities are examples of indirect expenses. You’d have these expenses even if you didn’t have a home office.

If you own your home, potential indirect expenses typically include mortgage interest, property taxes, home insurance, utilities, and maintenance. You can't deduct the principal portion of your mortgage payment, which is the amount borrowed for the home. Instead, you’re allowed to recover a part of the cost each year through depreciation deductions, using formulas created by the IRS.

Allowable indirect expenses actually turn some of your personal costs into home office business deductions, which is fantastic! They’re partially deductible based on the size of your office as a percentage of your home—unless you use a simplified calculation, which I’ll cover next.

How to calculate your home office tax deduction

If you qualify for the home office deduction, there are two ways you can calculate it: the standard method or the simplified method.

The standard method requires you to keep good records and calculate the percentage of your home used for business. For example, if your home office is 12 feet by 10 feet, that’s 120 square feet. If your entire home is 1,200 square feet, then diving 120 by 1,200 gives you a home office space that’s 10% of your home.

In this example, 10% of your qualifying expenses could be attributed to business use, and the remaining 90% would be for personal use. If your monthly power bill is $100 and 10% of your home qualifies for business use, you can consider $10 of the bill a business expense.

To claim the standard deduction, use Form 8829, Expenses for Business Use of Your Home, to figure out the expenses you can deduct and then file it with Schedule C, Profit or Loss From Business.

The simplified method doesn’t require you to keep any records, which makes it incredibly easy to claim. You can claim $5 per square foot of your office area, up to a maximum of 300 square feet. So, that caps your deduction at $1,500 (300 square feet x $5) per year.

The simplified method requires you to measure your office space and include it on Schedule C. It works best for small home offices, while the standard approach is better when your office is bigger than 300 square feet. You can choose the method that gives you the largest tax break for any year.

No matter which method you choose to calculate a home office tax deduction, you can't deduct more than your business's net profit. However, you can carry them forward into future tax years.

Also note that business expenses that are unrelated to your home office—such as marketing, equipment, software, office supplies, and business insurance—are fully deductible no matter where you run your business.

If you have any questions about qualifying business expenses, home office expenses, or taxes, consult with a qualified tax accountant to maximize every possible deduction and save money. The cost of working with a trusted financial advisor or tax pro is worth every penny.

Continue reading

5 Options for Your Retirement Account When Leaving a Job

One of the most common retirement questions I receive is what to do with a retirement account when leaving a job. Knowing your options for managing a retirement plan with an old employer is essential because most people change jobs many times throughout their careers. And millions of Americans remain out of work during the pandemic.

When you have a workplace retirement plan such as a 401(k) or 403(b), you can take your vested balance with you when you leave.

Fortunately, when you have a workplace retirement plan such as a 401(k) or 403(b), you can take your vested balance with you when you leave. It doesn't matter if you quit, get fired, or get laid off, the same rules apply. 

This post will cover five options for managing your retirement account when your employment ends. You'll learn the rules for handling a retirement plan at an old job and the best move to create a secure financial future.

Why should you use a retirement account?

Investing money using one or more retirement accounts is wise because they come with terrific tax advantages. They defer or eliminate the tax on your contributions and investment earnings, which may allow you to accumulate a bigger balance than with a taxable brokerage account.

Investing money using one or more retirement accounts is wise. If you have a retirement plan at work but aren't participating in it, now's the time to enroll!

So, if you have a retirement plan at work but aren't participating in it, now's the time to enroll! Contribute as much as you can, even if it's just a small amount. Make a goal to increase your contribution rate each year until you're putting away at least 10% to 15% of your pre-tax income.

FREE RESOURCE: Retirement Account Comparison Chart (PDF)—a handy one-page download to see the retirement account rules at a glance.

What is a retirement account rollover?

Don't make the mistake of thinking that once you leave a job with a 401(k) or a 403(b) you can't continue getting tax breaks. Doing a rollover allows you to withdraw funds from a retirement plan with an old employer and transfer them to another eligible retirement account.

When you roll over a workplace retirement account, you don't lose your contributions or investment earnings. And if you're vested, you don't lose any money that your employer may have put into your account as matching funds.

The main rule you must follow when doing a retirement rollover is that you must complete it within 60 days once you begin the process.

The main rule you must follow when doing a retirement rollover is that you must complete it within 60 days once you begin the process. If you miss this deadline and are younger than age 59½, the transaction becomes an early withdrawal. That means it is subject to income tax, plus an additional 10% early withdrawal penalty.

If you're a regular Money Girl podcast listener or reader, you know that I don't recommend taking early withdrawals from retirement accounts. Paying income tax and a penalty is expensive and reduces your nest egg.

If you complete a traditional rollover within the allowable 60-day window, you maintain all the funds' tax-deferred status until you make withdrawals in the future. And with a Roth rollover, you retain the tax-free status of your funds.

What are your retirement account options when leaving a job?

Once you're no longer employed by a company that sponsors your retirement plan, there are four options for managing the account. 

1. Cash out your account

Cashing out a retirement plan when you leave a job is the easiest option, but it's also the worst option. As I mentioned, taking an early withdrawal means you must pay income tax and a 10% penalty. 

Cashing out a retirement plan when you leave a job is the easiest option, but it's also the worst option.

Let's say you have a $100,000 account balance that you cash out. If your average rate for federal and state income taxes is 30%, and you have an additional 10% penalty, you lose 40%. Cracking open your $100,000 nest egg could mean only having $60,000 left, depending on how much you earn.

Note that if your retirement plan has a low balance, such as $1,000 or less, the custodian may automatically cash you out. If so, they're required to withhold 20% for taxes (although you may owe more), file Form 1099-R to document the distribution, and pay you the balance. 

2. Maintain your existing account

Most retirement plans allow you to keep money in the account after you're no longer employed if you maintain a minimum balance, such as more than $5,000. If you don't have the minimum, but you have more than the cash-out threshold, the custodian typically has the authority to deposit your money into an IRA in your name.

The downside to leaving money in an old retirement account is that you can't make additional contributions because you're not an employee. However, your funds can continue to grow there. You can manage them any way you like by selling or buying investments from a set menu of options.

The downside to leaving money in an old retirement account is that you can't make additional contributions.

Leaving money in an old retirement plan is certainly better than cashing out and paying taxes and a penalty, but it doesn't give you as much flexibility as you you would get with the next two options I'm going to talk about.

I only recommend leaving money in an old employer's retirement plan if you're happy with the investment choices and the fund and account fees are low. Just make sure that the plan doesn't charge you higher fees once you're no longer an active employee.

Another reason you might want to leave retirement money in an old employer's plan is if you're unemployed or have a job that doesn't offer a retirement account. I'll cover some special legal protections you'll get in just a moment.

3. Rollover to an Individual Retirement Arrangement (IRA)

Another option for your old workplace retirement plan is to roll it into an existing or new traditional IRA. If you have a Roth 401(k) or 403(b), you can roll it over into a Roth IRA. The deadline to complete an IRA rollover is 60 days.

Your earnings in a traditional IRA would continue to grow tax-deferred, just like in your old workplace plan. And earnings grow tax-free in a Roth IRA, like a Roth account at work. 

Here are a couple of advantages to moving a workplace plan to an IRA:

  • Getting more control. You choose the financial institution and the investments for your IRA.  
  • Having more flexibility. With an IRA, there are more ways to tap your funds before age 59½ and avoid an early withdrawal penalty than with a workplace account. That rule applies to several exceptions, including using withdrawals for medical bills, college expenses, and buying or building your first home.

Here are some downsides to rolling over a workplace plan to an IRA:

  • Having fewer legal protections. Depending on your home state, assets in an IRA may not be protected from creditors.  
  • Being ineligible for a Roth IRA. When you're a high earner, you may not be allowed to contribute to a Roth IRA. However, you can still manage the account and have tax-free investment earnings.

If you want more control over your investment choices, think you'll need to make withdrawals before retirement, are self-employed, or don't have a job with a retirement plan to roll your account into, having an IRA is a great option.

4. Rollover to a new workplace plan

If you land a new job with a retirement plan, it may allow a rollover from your old plan once you're eligible to participate. While the IRS allows rollovers into most retirement accounts, employer plans aren't required to accept incoming rollovers. So be sure to check with your new plan administrator about what's possible. 

Once you initiate a transfer from one workplace plan to another, you must complete it within 60 days to avoid taxes and a penalty.

Here are some advantages of doing a workplace-to-workplace rollover:

  • More convenience. Having all your retirement savings in one place may make it easier to manage and track.  
  • Taking early withdrawals. Retirees can begin taking penalty-free withdrawals from workplace plans as early as age 55.  
  • Avoiding Roth income limits. Unlike a Roth IRA, there are no income restrictions for participating in a Roth workplace retirement account.  
  • Getting more legal protections. Workplace retirement plans are covered by the Employee Retirement Income Security Act of 1974 (ERISA), a federal regulation. It doesn't allow creditors (except the federal government) to touch your account balance.

Some downsides to transferring money from one workplace plan to another include:

  • Having less flexibility. You can't take money out of a 401(k) or a 403(b) until you leave the company or qualify for an allowable hardship. It doesn't come with as many withdrawal exceptions compared to an IRA. 
  • Getting less control. You may have fewer investment choices or higher fees than an IRA, depending on the brokerage firm. 

5. Rollover to an account for the self-employed

If you left a job to become self-employed, having an IRA is a great option. However, there are other types of retirement accounts that you might consider, such as a solo 401(k) or a SEP-IRA, based on whether you have employees and on your business income. 

Read 4 Ways to Start a Retirement Account as a Self-Employed Freelancer or 5 Retirement Options When You're Self-Employed for more information. 

When is a Roth rollover allowed?

For a rollover to be tax-free, you must use a like account. For example, if you have a traditional 403(b), you must rollover to another traditional retirement account at work or to a traditional IRA.

If you move traditional, pre-tax funds into a post-tax, Roth account, you must pay income tax on any amount that wasn't previously taxed. That could leave you with a massive tax liability. If you want a Roth, a better move would be to open a Roth account at your new job or to start a Roth IRA (if your income doesn't make you ineligible to contribute). 

Where should you move an old retirement account?

The best place for your old retirement account depends on the flexibility and legal protections you want. Other considerations include the quality of your old plan, your income, and whether you have a new job with a retirement plan that accepts rollovers.

The best place for your old retirement account depends on the flexibility and legal protections you want.

The goal is to position your retirement money where you can keep it safe and allow it to grow using low-cost, diversified investment options. If you have questions about doing a rollover, get advice from your retirement plan custodian. They can walk you through the process to make sure you choose the best investments and don't break the rollover rules.

Continue reading

3 Tax Scams You Need to Watch Out For

According to the Internal Revenue Service (IRS), there was a 400% increase in phishing and malware incidents during the 2016 tax season. And tax scams extend far beyond email and malware to include phone scams, identity theft and more.  While the April 15 filing deadline still feels far away, as Yogi Berra said, “It ain’t… Read More

The post 3 Tax Scams You Need to Watch Out For appeared first on Credit.com.

Continue reading