Tax Basics: Employed vs Self-Employed  


As more and more clients are starting businesses, picking up side consulting gigs or selling crafts online, this post focuses on the tax differences between being an employee vs being self-employed.

1) You are in charge of tracking your income and expenses when you are self-employed.

All income is taxable, absent a specific exclusion in the IRS code.  You don't need to track your income when you are an employee because you receive a W-2 from your employer summarizing your taxable income.

When you are self-employed, you are responsible for tracking your income and expenses.  I recommend using an accounting software like Quickbooks Online, but some people choose to just use an Excel spreadsheet.  Depending on what goods & services you are selling, you may get a summary of income earned at the end of the year.  For example, if you are providing consulting services, your clients need to send you a 1099-MISC form at the end of the year if they paid you $600 or more.  If you earned less than $600 from a given client, and don't receive a 1099-MISC, you still need to report the income.  The annual tax forms you are required to file depend on the type of entity you choose for your business.  The majority of my clients are sole proprietors or single-member LLC's which requires them to complete the Form Schedule C for federal tax purposes.  I recommend touching base with an accountant, at least in the beginning, to make sure you choose the best entity for your situation and get set up correctly.

2)  You need to pay taxes as you go, regardless of how you get paid.

The IRS requires us to pay a certain amount of tax throughout the year rather than everything at once at tax time.  This is very easy to do as an employee because you can have your employer withhold taxes from your wages with each paycheck.

The self-employed, on the other hand, likely need to pay quarterly estimated tax payments.  If you also have a job as an employee, in addition to your self-employment earnings, you can choose to withhold additional taxes to cover your required amount due for the self-employment income.  Likewise, if you are married and filing jointly with a spouse who is an employee, you can withhold more taxes from your spouse's earnings.  An accountant can help you figure out how much you are on track to owe and make sure you are doing it correctly.

3)  Now may be the time to pay for a professional tax preparer.

If you don't already have a tax preparer, consider getting one if you are starting to earn self-employment income.  My experience has been that the tax preparer can help save you time and money by doing it right the first time.  Tax preparers deal with the tax code everyday, know the ins and outs on what you can deduct, and have survived IRS audits.  I am always trying to meet new tax preparers in San Diego to use as referrals for my clients.  If you have a tax preparer you love who is taking new clients, please share their info!

This article is for general informational purposes and shouldn't be taken as a substitute for tax advice.


Are you eligible for the American Opportunity Tax Credit?

If you paid for higher education costs in 2013, be sure to speak with your tax preparer to see if you may benefit from this credit. What is it?

The American Opportunity Tax Credit (AOTC) modifies the Hope Tax Credit. It allows you to take a tax credit for qualified higher education costs including tuition, certain fees and course materials. See IRS Publication 970 for a complete list. It does not include room & board.

How much is it?

The credit amount is 100% on the first $2,000 of expenses and 25% of the next $2,000, so $2,500 max per year.

How long can I use it?

For four years! This is better than the Hope credit that could be used only for two years.

What exactly is a tax credit?

A tax credit reduces your tax liability dollar for dollar. It is preferable to a “deduction” which reduces your taxable income.

Can anyone claim it for higher education costs for themselves or a dependent?

If you are filing singly, your modified Adjusted Gross Income (AGI) has to be less than or equal to $80,000. For married folks filing jointly, the number is $160,000. After these income levels, the credit starts to phase out until it is no longer available.

How do I claim the credit?

Complete form 8863 and attach it to the 1040 when you file your tax return.

What if I only used 529 plan money for education expenses?

You can’t double dip. That is why I recommend that my clients use their own funds for the first $4K to make sure they can take advantage of the credit, then 529 funds after that.


Are you Self-Employed?

Consider a SEP-IRA. A Simplified Employee Pension (SEP) plan is a retirement savings vehicle available to those who are self-employed. This past year, I came across a handful of new clients who were self-employed and not aware of a SEP-IRA and its benefits. The following is a summary focused towards business owners who do not have employees. You can use the SEP-IRA with employees, but I do not go into the details of that below. A SEP-IRA follows the same investment, distribution and rollover rules as traditional IRA’s. The amount you can contribute is based on a formula. The IRS demonstrates this with an example here.

The due date for contributions is the due date of your business income tax return including extensions. There is flexibility with the contributions in that you can contribute in some years and not others. The SEP can also be paired with other retirement savings vehicles. For example, you can contribute to a Roth IRA in addition to a SEP-IRA.

As you prepare to gather information for your taxes in the next few months, remember the SEP-IRA. It may be a good retirement plan for you. To learn more, review IRS Publication 560 and check with your tax preparer.


Image courtesy of hin255/