Tax time can be particularly difficult for independent contractors. Because the self-employed don’t have a portion of each paycheck automatically set aside to cover payroll taxes, the tax filing process requires thinking about taxes throughout the year—not just in the month or two before the filing deadline. In particular, focusing on what tax deductions and credits are available can help ensure that a good year business-wise doesn’t turn into a problem tax-wise.
One of the most valuable deductions an independent contractor should take care to claim is the health insurance expense deduction. Trey Luby, the director of Luby, LLC, a New Orleans-based accounting firm, explains. “Your net income from being an independent contractor is considered self-employment income, thereby allowing you to deduct your health insurance premiums paid as self-employed health insurance expense—on page 1 of Form 1040, line 29,” says Luby. “This results in lowering your taxable income.”
An independent contractor can also leverage retirement savings to reduce tax bills. There are a variety of tools, depending on the specifics of your financial situation, but Luby suggests looking at the SEP-IRA. He says, “The amounts you can contribute are a percentage of your net self-employment income and usually allow you to make greater contributions than to just a Traditional or Roth IRA.”
Certain deductions that independent contractors are eligible for can often be difficult to claim. The home office deduction, for example, has historically caused problems with tax returns, particularly for people who are self-employed. However, Luby points out, “…the IRS has instituted a new optional simplified method of calculating this use.” He suggests checking the criteria, including the exclusive use and regular use tests to see if you can deduct a part of your home expenses. The home office deduction is available to contractors who rent, as well as those who own their homes.
To prove eligibility for each deduction an independent contractor might take advantage of, it’s important to collect the necessary supporting paperwork, including receipts. Even setting up a simple series of folders to track paperwork each month can help keep documents in a manageable state for tax time. Maintaining records electronically can also be useful—accounting and bookkeeping software can automate most of the work, though you will need to hang on to your paper receipts and contracts, just in case. If you have a tax preparer help you with your return, follow his suggestions for setting up your files so the process goes faster.
Those records should include copies of the quarterly estimated tax payments that independent contractors are required to submit in place of the payroll taxes paid into the system by regular employees. Because these payments are required, it’s important to take whatever steps necessary to make sure they get in on time—set aside money in advance, set reminders on your calendar, and use any other sytsem you find necessary. Otherwise, an independent contractor risks facing penalties come tax time.
Looking for more tips on managing your finances as a freelancer? Check out Budgeting Tips for Freelance Professionals and Budgeting for Irregular Incomes: A Step-by-Step Plan.