If you’ve recently landed a gig driving for Uber, walking dogs for Rover, shopping for Instacart, or doing odd jobs on TaskRabbit, you need to be aware that this extra 1099 income may generate a tax bill. Similarly, if you work as a freelancer, ranch hand, doctor, dentist, veterinarian, lawyer, accountant, hairdresser, optometrist, or countless other positions, you may get paid as a 1099 worker, and you have to plan for your tax obligations.
Want to avoid owing tax on your 1099 income? Then, you need to understand how the taxes on this income work and plan accordingly. Keep these tips in mind.
Make a Tax Plan Early
To avoid owing tax on 1099 income, you need to be aware that this income comes with extra tax obligations. If you are used to having your boss withhold tax from your paycheck, getting into the habit of planning for a tax bill can be challenging, but you need to make a plan.
A lot of freelancers get excited about the extra money in their pockets, and they spend all the cash they earn. Often, these workers are used to receiving a tax refund, and when they file their return with 1099 income, they end up shocked at their tax bill.
Don’t get into this trap. Even just a few thousand dollars in 1099 income can lead to a tax bill.
Get to Know Your Business Deductions
Whether you’re an optometrist earning $120,000 a year in 1099 income or someone who earns $500 a month delivering food for DoorDash, the Internal Revenue Service (IRS) considers you to be a small business owner, and that means you can write off business expenses. As a result, you don’t have to pay tax on all of your 1099 income — you just face tax on your profits.
Your profits are your 1099 income minus your business expenses. For instance, if you earn $6,000, but you spend $1,000 in qualifying business expenses, your profit is $5,000, and you only have to pay tax on that amount.
Business expenses consist of any reasonable costs you incur as a result of doing business, and they can include the following:
- Supplies such as envelopes for an office or cleaning products for a housekeeping company
- Phone and internet bills
- Subscriptions for your business
- Business insurance
- Fees paid to professionals such as attorneys, accountants, or consultants
- Mileage or a portion of vehicle expenses if you use your vehicle for work
- Business travel expenses
- Up to 50% of the reasonable cost of business meals
- Interest and fees charged on business loans or bank accounts
- Payments made to contractors or employees
- Rent on business property
- Expenses related to the home office deduction
If you use part of your home exclusively for your business or if you regularly meet clients in your home, don’t forget to claim the home office deduction. You can claim a percentage of your home’s bills (rent, mortgage interest, electricity, water, garbage removal, etc.) as a business deduction, and this can add up. Your home office doesn’t need to be its own room — if you have minimal space, it can be a section of another room.
You can also write off large expenses such as computers, vehicles, and other business equipment. Typically, you write off a small portion of these expenses every year, but if you opt to take advantage of the Section 179 deduction, you can write off qualifying large expenses in the year of purchase. This rule can reduce or even eliminate your tax bill, but you need to keep in mind that you’re compromising your deductions for future years.
Track Your Expenses
Once you understand the potential business expenses in your situation, you need to track these expenses diligently. Gathering receipts and old bills at tax time is a nightmare, and you are guaranteed to miss some expenses if you take this route.
Set up a system so that you can easily track your expenses as soon as you incur them. Try these ideas:
- Email yourself receipts and save them in a folder.
- Subscribe to online accounting software like QuickBooks Self-Employed.
- Use an expense tracking app.
- Throw expenses records in a drawer and enter them in a spreadsheet once a month.
The exact method doesn’t matter as long as you’re tracking expenses consistently.
Be Aware of Self Employment Taxes
Self-employment taxes are significant. As of 2019, independent contractors have to pay 2.9% of their income for Medicare premiums and 12.4% for Social Security contributions. In contrast, when you’re an employee, you only pay half of these amounts, and your employer pays the other half.
You do not have to pay Social Security on earnings over $132,900, but you have to pay Medicare on all earnings. Ultimately, many factors can affect your final amount due, but for easy reckoning, you should expect to pay 15.3% of your profits in self-employment tax.
For instance, if you have $100,000 in profit from your 1099 income, you owe $15,300 in self-employment tax.
Estimate Your Tax Obligation
You also need to plan for federal and state income tax on your 1099 income. Form 1040-ES (Estimated Tax for Individuals) can guide you through calculations to help you nail down exactly what you’re likely to owe, and then, you can plan so you don’t get stuck owing anything at tax time.
The exact calculations are complex, but here’s a simplified overview, so you know what to expect:
1. Start With Your Adjusted Gross Income
Adjusted gross income (AGI) refers to your income minus “above line adjustments.” To calculate AGI, add up all your 1099 income plus any other amounts you receive from wages, capital gains, alimony, rental income, etc. Then subtract retirement plan contributions, healthcare savings account (HSA) deductions, half of your self-employment tax (estimated above), alimony you paid that is included in the recipient’s gross income, and losses from the sale of property.
2. Subtract Your Deductions
Once you find your AGI, subtract your deduction from that amount. Most taxpayers take the standard deduction, and as of 2020, the standard deduction is $12,400 for individuals and $24,800 for couples filing jointing. Alternatively, you can itemize, which means you add up mortgage interest, state and local taxes (SALT) up to $10,000, medical bills over 10% of your AGI, and other itemizable expenses.
3. Calculate Your Qualified Business Income Deduction
If you qualify for the qualified business income deduction, you can claim a deduction worth up to 20% of your business income, but the exact calculations and criteria are complicated. Once you determine your eligibility and estimate this deduction, subtract that amount from your AGI along with your standard or itemized deductions.
4. Figure Out Your Estimated Income Tax
The difference between your AGI and your deductions is your taxable income, and Income tax varies based on how much you earn and how you file. For instance, if you file as an individual, you pay 10% in income tax on taxable income between 0 and $9,875, but you face a rate of 12% on income between $9,876 and $40,125. As your income climbs, so too does the income tax rate.
For income received in the tax year 2020, you can use the following income tax rates .
Individual Taxpayers 2020 Tax Rates
|Taxable Income Between:||Tax Amount Due|
|$0 – $9,875||10% of taxable income|
|$9,876 – $40,125||$987.50 + 12% of amount over $9,875|
|$40,126 – $85,525||$4,617.50 + 22% of amount over $40,125|
|$85,526 – $163,300||$14,605.50 + 24% of amount over $85,525|
|$163,301 – $207,350||$33,271.50 + 32% of amount over $163,300|
|$207,351 – $518,400||$47,367.50 + 35% of amount over $207,350|
|$518,400+||$156,235 + 37% of amount over $518,400|
Married Filing Jointly Returns
|Taxable Income Between:||Tax Amount Due|
|$0 – $19,750||10% of taxable income|
|$19,751 – $80,250||$1,975 + 12% of amount over $19,750|
|$80,251- – $171,051||$9,235 + 22% of amount over $80,250|
|$171,051 – $326,600||$29,211 + 24% of amount over $171,050|
|$326,601 – $414,700||$66,543 + $32% of amount over $326,600|
|$414,701 – $622,050||$94,735 + 35% of amount over $414,700|
|$622,051+||$167,307.50 + 37% ofamount over $622,050|
5. Subtract Your Credits
Now that you know your estimated income tax, you should subtract your credits from that amount. Depending on your situation, you might qualify for the foreign tax credit, education credits, child care expense credits, and the child tax credit, which is up to $2,000 per child.
6. Add Self-Employment Tax
If you get a negative number after you subtract your credits, round up to zero. In all other cases, add your self-employment tax (the basic calculations are explained above) to your estimated income tax.
Once you’ve worked through the above steps, you should have a decent estimate of your annual tax bill, but keep in mind that there are extra considerations if you’re a fisher or farmer, if you have to pay alternative minimum tax (AMT), or if you qualify for the earned income credit (EIC), additional child tax credits, or fuel tax credits.
Additionally, if you have a job with a traditional employer, they probably withhold some income tax from your paycheck. Remember to take that into account when you estimate how much your tax bill is going to be.
Increase Withholding at Your Other Job
If you have another job, consider asking your employer to increase how much they withhold from your paycheck. To figure out how much you should withhold, check out the IRS’s Tax Withholding Estimator. You will also have to give your employer a new W-4 form.
Set Aside the Estimated Tax on Your 1099 Income
Now that you have an estimate of your tax liability, you need to commit to setting aside those funds. You can break your tax bill into 52 increments and set aside that amount every week. For instance, if you anticipate owing $5,200 in tax, you should set aside $100 a week.
Alternatively, you may want to put a percentage of the payments you receive into a savings account to cover your tax bill. To figure out the percentage, take your estimated tax owed and divide that into the amount you expect to get paid during the year. If you are going to receive $70,000 in 1099 income and you think you’re going to owe $7,000 in tax, set aside 10% of every payment.
Make Quarterly Tax Payments
During your first year with 1099 income, you usually don’t have to pay quarterly, so you can save up your money during the year to cover your tax bill. After your first year, however, you usually need to pay quarterly or you risk facing late payment penalties and a big tax bill.
Budget for your quarterly payments and make them on time. They are due on April 15, July 15, October 15, and Jan 15 or the following business day if those dates fall on a weekend or a holiday.
Consider Turning Your Business Into an S-Corp
If you have 1099 income, turning your business into an S-corp allows you to save money on self-employment taxes. When you elect to be taxed as an S-corp, all the 1099 income and payments you receive from clients go directly to your business. You deduct business expenses as explained above, but then, you also pay yourself a salary.
The salary has to be fair for your industry. To give you an example, imagine you’re an accountant, and you pay yourself an $80,000 a year salary. That’s fair because it’s about the median annual income for an accountant.
On your salary, you pay your half of Social Security contributions and Medicare premiums, and the S-corp pays the other half. Because you are the sole owner of the S-corp, you are responsible for both amounts, so you are essentially paying self-employment tax on your salary.
The remaining amount is your S-corp’s profits. You have to report this money as income on your tax return, but although you may incur income tax, you do not have to pay self-employment tax. Here’s an example of how this works:
- $150,000 received in 1099 income and from clients
- -$20,000 in business expenses
- -$80,000 paid to yourself as salary
- $50,000 in S-corp profits which may face income tax but not self-employment tax
Based on the 15.3% self-employment tax rate, you save $7,650 in this scenario. That is $50,000 x 0.153.
Make sure you keep detailed records of your business. If you get audited, you need receipts and invoices to back up your business deductions, and without this information, you may end up owing even more on your tax bill.
If you earn a lot of 1099 income, you are going to have some tax liability. But by following the tips above, you can reduce your tax bill as much as possible and avoid facing a large bill when you file your return.
Are you already struggling with a tax bill from 1099 income? We can help. Contact us today, and we will put you in touch with a tax debt specialist who can help you amend old returns and reduce your tax bill, plan for next year, set up payments with the IRS, remove penalties and fees, and find other solutions for your situation.