Over the past decade, I have done a ton of freelancing work on a lot of different projects, and that means taxes are sometimes incredibly difficult and confusing. This time of the year, I’m waiting for a variety of 1099s to arrive in my mailbox before I can even think about filing taxes and it will be a long process even when I have everything ready.
I’ve come to realize that the key to making this all work out without pulling your hair out and panicking a few times a year is to have a smart system in place at the start of each year. You have to be organized. You have to have a plan.
Here’s the truth: the system of personal income taxes in the United States is not friendly for freelance workers. There are many aspects of the whole tax system that put an unnecessary burden on people who aren’t hourly or salaried employees. There are rewards for freelance work, don’t get me wrong. The flexibility and variety of challenges can be amazing. However, those rewards come with extra challenges, and taxes definitely fall into that camp.
If you are new to freelancing work, or even if you’ve done it for a few years and are struggling with handling taxes, here are some key tips that turn taxes into something manageable for me.
Have a robust system for organizing everything.
I’m not going to specifically tell you how to organize everything (though I will describe my own system in a bit). Rather, I’m going to say this: you need to have some sort of organizing system for your tax-related documents. If you don’t, you are going to have an extremely confusing and potentially panic-inducing mess when you actually have to file your taxes.
Here’s what I do. I have a series of manila envelopes into which I put hard copies of every document that could potentially be related to my income taxes each year. I keep an envelope for receipts of work-related expenses. I keep an envelope of all invoices. I keep an envelope of stubs for all payments received, no matter the source.
Along with that, I keep a very detailed log of every dollar that comes into my pocket or goes out of my pocket as a result of my work. Specifically, I keep a spreadsheet document for each year, in which I have a tab that lists income and another tab that lists expenses.
Whenever I receive any kind of income, I record the date, the amount, and the person or group that paid me. Whenever I have any kind of expense related to my work in any way, I record the date, the amount, who I paid, and what that payment was for.
Every single entry in this spreadsheet is backed up with a paper document of some kind in one of those envelopes as well as digital documents stored in an encrypted computer folder (the spreadsheet is kept in that folder, too).
At the start of each year, I start a new set of envelopes and computer folders and a new spreadsheet for all of this stuff and set aside the old stuff for taxes that spring.
You don’t have to duplicate this system, but I strongly encourage you to have a similar system for yourself. You absolutely need to document every freelance dollar you bring in and every expense you have. The better organized you are, the easier it will be to file your taxes each spring. The less organized you are, the more likely it is that taxes will be extremely stressful and potentially come with expenses that are far beyond what you can handle.
Let’s talk specifically about expenses.
You can deduct a lot of things as a freelancer, but you need to keep careful track of them.
The one thing that the IRS does nicely for freelancers is that they’re pretty flexible when it comes to deductions for work-related expenses, provided you’re not trying to abuse and scam the system with personal expenses under that umbrella. If there’s something you legitimately need purely for professional reasons, you can almost always deduct it from your taxes.
Having said that, don’t try to cheat this system. Don’t try to squeeze in personal expenses as deductions, because if you’re hit with an audit and you can’t validate everything, you’re going to get hit hard with tax penalties. The little bit you’ll save from sliding in something that isn’t strictly professional isn’t worth the expense and headaches from getting audited with fishy stuff on your taxes.
That being said, it is really worth your while to keep track of all of your professional expenses from freelance work. Keep every receipt and keep a running list of your expenses throughout the year, as described above. Everything you list will cut your tax bill at the end of the year and keep more of your hard-earned money in your pocket. This doesn’t mean you should spend freely, but that if you do decide an expense is worthwhile, there is strong financial motivation to keep track of it so you can easily incorporate it into your taxes. It will pay off.
Put aside at least 30% of your income (after work expenses) for taxes.
Yes, 30%. If you live in a state with state income taxes, I’d put aside even more. I’m not remotely exaggerating here.
Your freelance income is going to be hit with federal, state, and local income tax, which will be painful enough, but what will really hit home is the self-employment tax.
What is that, you might ask? Self-employment tax is how you pay for your share of Medicare and Social Security, benefits you won’t enjoy until retirement. When you’re traditionally employed, your employer pays for half of that, you pay for the other half, and it’s quietly taken out of your paycheck (usually labeled as FICA on your paycheck stub).
If you’re self employed, you’re responsible for all of it. That adds up to 15.3% of the first $132,900 of net income (this year; the income level goes up slowly over time) plus 2.9% on the net income in excess of $132,900.
So, that 30% I quoted you? That covers your self-employment tax along with about 15% of your income for income tax. You may want to consider putting aside even more than 30%.
Personally, I use a separate savings account for this. I move 30% of my income out of each freelancing payment I receive right into that account and I transfer it back into checking shortly before I file my taxes quarterly.
Yes, quarterly. The fun isn’t done yet.
Pay quarterly estimated income taxes if at all possible.
Most traditional employees file taxes once a year, and as a freelancer, you’ll do the same. However, the IRS actually wants their money every three months rather than once a year, and it’s well worth your time to actually pay them quarterly rather than waiting until your annual window for filing taxes.
Roughly once every three months, you should complete Form 1040-ES and submit it to the federal government, along with payment. This is supposed to be a quarter of your estimated total tax bill for the year.
To make matters more frustrating, the IRS expects you to be able to accurately estimate this well in advance. Often, freelancers have little idea of their exact October income in February, so it tends to be fairly inaccurate. What I usually do is make my absolute best guess as to what I’m going to make this year and calculate my estimated taxes based on that.
What if you get it wrong? The IRS gives you some breathing room on this. As long as you’re reasonably close to paying a quarter of your actual tax bill every three months, you’ll be fine. I usually base mine on my earnings for the previous year and estimate just a bit high, because the loss of paying a bit extra on my quarterly payments is worth avoiding penalties. Yes, penalties — you will be hit with an additional tax penalty if you’re too far off.
So, what happens if you just don’t do this? Well, when you file your taxes in the spring, you’ll not only owe your full tax bill, you’ll also owe a penalty for underpayment (this also happens if you didn’t pay 90% of your total tax bill across your quarterly payments in the previous year). It’s not overwhelming, but it is stiff enough that you’re better off paying quarterly estimated taxes if at all possible.
Use tax software you trust or have a trusted tax filer handle your preparations for you.
Does this all sound complicated? If you simply keep good records of every dollar that comes in and track all of your expenses and make sure to pay your quarterly taxes, it’s not too bad. However, that still leaves you with a lot of information to include when you file your taxes in March or April.
My honest suggestion is that if you’re doing much freelancing work at all, use tax software for filing your taxes or hand your documents over to a tax preparer. If you attempt to do this by hand yourself, with all of the extra forms and entries you’ll have to make, the likelihood of a mistake is high and being audited as a freelancer can be a real mess.
I have used Turbo Tax for many years and stick with it despite some quibbles and despite trying other tax packages (for researching articles for The Simple Dollar). It handles everything I do quite well, including producing 1040-ES forms for my estimated taxes at both the federal and state level so that it’s very easy to file them over the course of the next year.
Even though this is challenging, the rewards are still worth it.
Freelancing work offers a degree of freedom that’s very hard to find in other professional situations, even if it does make tax filing more difficult and taxes more costly. However, if you’re able to keep track of basic financial records and are somewhat organized, these steps aren’t too difficult to navigate.
In an ideal world, the federal government would make income taxes much easier for freelancers. Until then, the best thing you can do is keep careful records, make sure you pay your taxes each quarter, and use robust software or a tax preparer when filing taxes in the spring.