Every worker, freelance or not, is undoubtedly familiar with income taxes: the percentage of your income that’s paid to the Federal, state, and sometimes local government. (The rest of this post speaks primarily on Federal taxes.)
When you’re full-time employed by an employer, the employer will typically withhold taxes from your pay. They send the withholdings to the IRS on your behalf. But, when you’re fully self-employed, it’s your responsibility to withhold your taxes and pay that amount the government on a quarterly basis.
Taxes are paid as a percentage of your income. There’s not a flat percentage that applies to everyone, though some have been advocating this for years. Instead, the percentage you’re taxed on is based, in part, on how much you make and how file your taxes (by yourself or with a spouse). The tax brackets are: 10%, 15%, 25%, 28%, 33%, and 35%. The more you make, the higher the percentage of taxes you’re required to pay.
To make it even more confusing, not all your income is taxed at the same percentage. Let’s consider the tax brackets for a single tax filer, that is someone who’s not married and not head of household (2012 Tax Rates):
- $0 to $8,700 is taxed at 10%
- $8,700 to $35,350 is taxed at 15%
- $35,350 to $85,650 is taxed at 25%
- $85,650 to $178,650 is taxed at 28%
- $178,650 to $388,350, taxed at 33%
- Over $388,350 is taxed at 35%
If you make $50,000 this year, you’ll fall into the 25% tax bracket, but not all your income is taxed at 25% (thank goodness!). Instead, $8,700 is taxed at 10%, the next $26,650 is taxed at 15% and the final $14,650 is taxed at $25%. So, your tax rate (not considering any deductions) would really be 17%.
The income limits for each tax bracket varies depending on whether you file with your spouse or you claim head of household status.
The Federal government allows you to take deductions. Deductions reduce your income, sometimes dollar for dollar, or sometimes by only a percentage, lowering the amount of income that’s subject to taxation.
The IRS code allows for all kinds of deductions, but you may not qualify for all of them. For example, you can deduct medical expenses but only the amount that exceeds 7.5% of your adjusted gross income. Mortgage interest can also be deducted, but of course, you need to have paid interest on a mortgage to deduct the expense.
If you don’t have any deductions to itemize or the amount of your itemized deductions would be lower than the standard deduction, you may be able take a standard deduction instead. A single person under 65 would be able to take a $5,950 deduction for example. In our example above, the standard deduction would lower the taxable income from $50,000 to $44,050 and the amount of tax due from $8,530 to $7,042.50. If you’re married and file jointly, the standard deduction is higher. You can also take a deduction for qualified dependents.
There are some tax deductions you can take even without itemizing in addition to itemized deductions or the standard deduction. These are called above-the-line tax deductions. IRA contributions and student loan interest paid are examples.
Note, there may be a limit to the amount of a specific deduction you can take, e.g. you can only deduct $2,500 student loan interest paid, even if you paid more than that.
As self-employed workers, our qualified business expenses are deductible. The IRS says business expenses must be “ordinary and necessary” to be deductible, so, nothing outrageous and nothing that’s not required for your business. You can’t deduct personal expenses, unless it’s something that’s used partly for business. Even then, you can only deduct the percentage that’s used for business.
Taxes, especially for freelancers, are complicated and often difficult to do on your own, particularly by hand using tax forms and booklets. I’ve used TurboTax to file my taxes for several years. You can also hire someone to do your taxes, preferably someone with experience preparing taxes for self-employed workers.