Calculating income taxes is a royal pain, even when your situation is uncomplicated enough that you can file a 1040EZ Form. And if you're self-employed, be prepared for extra layers of complexity. Not only must you file an annual return with numerous additional forms and schedules, you're also responsible for paying quarterly estimated taxes, which can mean having to write a pretty hefty check while waiting for your clients to pay their overdue bills.
Add in that you're also responsible for funding your own health insurance and retirement and you may start to miss having an employer manage a portion of your financial affairs. (Although many people go into business for themselves precisely so they can call their own shots.)
Here are a few things to keep in mind when calculating your 2013 taxes:
First, some potentially good news for taxpayers who claim a home office deduction: You now may choose between the traditional method of calculating the business use of your home (which involves numerous calculations, filling out the onerous IRS Form 8829 and maintaining back-up records for years) and a new simplified option.
Under the new, so-called "safe harbor" method, you can simply claim a standard deduction of $5 per square foot for the portion of your home used regularly and exclusively for business, up to a maximum of 300 square feet -- a $1,500 limit.
Contrast that with the traditional method where you must calculate actual expenses of your home office expressed as a percentage of the square footage your home office consumes. For example, if your office takes up 12 percent of your house, you can deduct 12 percent of your electricity bill.
A few additional details:
- You can choose either method from year to year; however, once you've elected a method for a given tax year it's irrevocable.
- Whichever method you choose must apply consistently for all businesses you might operate from home.
- Under the safe-harbor method you cannot depreciate the portion of your home used for business in that particular year.
- With the new method you can still claim allowable mortgage interest, real estate taxes and insurance losses as itemized deductions on Schedule A. These deductions don't have to be allocated between personal and business use, as under the traditional method.
You'll need to weigh whether the recordkeeping hours you save justify the potentially smaller deduction -- especially if you have a large home office or considerable deductions. Suggestion: Look at last year's deduction amount and compare what it would have been using the $5 per square foot calculation, factoring in time spent doing the math.
A few other self-employment tax-filing considerations:
- In addition to the home office deduction, you generally can deduct many other business-related expenses, including: legal and accounting fees; professional dues and subscriptions; business insurance and licenses; professional training and education; professional equipment and software; maintenance/repairs; and business-related mileage, travel and entertainment.
- You can also deduct the full cost of medical, dental, vision and long-term care insurance premiums for you, your spouse and dependents, even if you don't itemize deductions. Note that under the Affordable Care Act, you can no longer be denied medical coverage because of preexisting conditions, and depending on your income level, you may qualify for coverage subsides.
- For more details on business expenses and deductions, see IRS Publication 535.
- You are responsible for paying 15.3 percent of net earnings in self-employment tax. Of this, 12.4 percent of your first $113,700 of net self-employment income goes to Social Security and 2.9 percent all net income (no limit) to Medicare. Regular employers split this cost 50-50 with employees (otherwise known as "FICA"). However, you do get to reduce your taxable income by 7.65 percent before calculating your self-employment tax; and then claim one-half of the tax as a deduction.
- Note: An additional 0.9 percent Medicare surtax now also applies to high-income taxpayers. See IRS Schedule SE for income threshold amounts and other instructions for calculating self-employment tax.
- A good way to lower your adjusted gross income (on which your tax amount is based) and save for your future is to contribute to an IRA, Simplified Employee Pension (SEP) IRA or other qualified retirement plan. You can claim a deduction even if you don't itemize. For more details, visit the IRS's Self-Employed Individuals Tax Center.
Bottom line: Income taxes are often more complicated for self-employed people and good record-keeping is essential. Unless you're an accounting whiz, consider hiring a tax professional or financial planner who specializes in self-employment issues. The penalties and fees they can help you avoid -- and hidden deductions they can uncover -- will probably more than pay for their fees. For tips on finding a tax professional, see my previous blog, Should You Hire a Tax Preparer?
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.
To participate in a free, online Financial Literacy and Education Summit on April 2, 2014, go to Practical Money Skills for Life.