If you've read through this tax guide, by now you've come to figure out that most of your deductions for self employed work aren't really deductions. They're expenses.
Most of what we talk about in this guide has to do with that income and those expenses. All of that gets handled in the income part of the income tax process.
And then there are your tax deductions. For most deductions, you have to choose whether to claim the Standard Deduction or whether it's better to itemize them.
That standard deduction is so high now that it's more unusual than ever to itemize. Unfortunately, that means if you take the standard deduction, there are a lot of things you can't claim.
Here's the other thing to think about in all of this. Tax deductions are different than business expenses. That difference is important, because expenses on Schedule C will lower your Self-Employment tax. Tax deductions are applied later, so they don't bring down those taxes.
With all that said,
There are four special deductions for independent contractors that don't fit on Schedule C OR in Itemized deductions.
The bad news is that those deductions won't bring down your self-employment tax. That's a flat rate and won't change because of deductions.
The good news is, they're handled outside of the itemized deductions. That means we can claim them even when just taking the standard deduction.
These are pretty substantial AND they're reserved just for the self-employed such as small business owners, sole proprietors, independent contractors and others who pay taxes for their business on their personal income tax forms.
We'll talk about each of these special deductions, and then talk about where you claim them on your 1040 tax return.
1. Self Employed Health Insurance
If you are self employed and have to purchase your own health insurance, you can deduct the premiums from your taxable income for income taxes. It will not reduce your profit and thus will not reduce your self employment tax.
There are a number of limitations to this. You have to have earned a profit and you cannot claim more than what your profit was. If you were eligible for subsidized health care through your employer or your spouse's employer, you may not qualify.
This deduction is taken on Schedule 1 that you would include with your tax form. Schedule 1 lists adjustments to income that don't rely on whether you itemize your deductions.
Some of the calculations can be a bit involved, so it's better if you have your tax pro help with your taxes on this deduction.
2. Retirement Savings for Self Employed Individuals
Anyone, whether self-employed or not, can save up to $6,000 in an Individual Retirement Account (or IRA). That money can be written off on Schedule 1 of your tax return, thus reducing your taxable income. If you're 50 or older, you can bump that up to $7,000 per year.
However, when you are self-employed, you have options that will let you save more than that $6,000 or $7,000 limit.
A Simple IRA lets you invest up to $14,000 tax free for any given. A SEP IRA will let you save up to $58,000 in a given year. There are a lot of different rules about how to set them up and you can find out more from this article by BankRate.
I'm not going to try to explain what qualifies and what doesn't. This is best to get with your financial planner or tax professional. You can also see IRS Publication 560.
One thing I will say about this: In the gig economy we have a huge tax advantage because we can write off all the miles that we drive. That means our taxable income is often far less than our actual income. Few people get this kind of advantage.
However, that also reduces our Self-Employment tax which covers Social Security. THAT means you will get lower Social Security benefits when you retire. It's really important that you set aside some of those savings in some form of retirement account to make up for that.
The deductions go on the same Schedule 1 as health insurance premiums. This means it would only deduct your taxable income for income tax but would not impact self employment tax.
Self Employment Tax Deduction
The deduction for self employment tax reduces is the one deduction that actually reduces both your self employment tax AND your income tax. Basically it's a deduction that allows you to write off the 'employer half' of your self employment tax.
An employer has to pay half of the employee's social security and medicare taxes. However, they can write that off as a business expense.
This deduction was given as a way to level the playing field for the self-employed.
We can't write this off on Schedule C, probably because we don't know yet what our self-employment tax will be when we're filling out Schedule C. That part comes later.
On your Schedule SE where you calculate your self employment tax, you take 7.65% off your business profit before you start calculating the self employment tax. What that's doing is deducting the employer half of social security BEFORE figuring out the final self-employment tax bill.
It's essentially the same as writing it off as an expense, just in a different way.
Unfortunately, that only reduces self-employment tax. What about income tax?
Line 14 of Schedule 1 (2021) has a place for that. It's the deductible part of self-employment tax. The deductible part is 50% of the total self-employment tax total on Schedule SE.
4. Qualified Business Income Deduction
If you had a profit on your Schedule C, you can most likely deduct 20% of that profit from your taxable income. This is the one deduction of the four that actually goes directly on Form 1040.
Of course, there's another form to fill out before it gets there. On form 8895 you list your qualified business income from whatever businesses you own. There's a lot of other lines on there that apply to specialized situations.
On form 8895, you figure out your qualified income. Then multiply that by 20%. That amount gets moved over to Form 1040 Line 13 (for the 2021 form, anyway).
For example, if you had $20,000 profits delivering for Doordash, Grubhub, Uber Eats, Instacart and other gig platforms, you can take a $4,000 income tax deduction, whether or not you itemize.
That's pretty huge.
Here's how it works. This is a special deduction for pass through business income.
What pass through means is that your business profits are personal income. You pay taxes on those profits as though they were any other type of personal income. This is called a pass through.
The IRS has a list of qualifications for what type of business qualifies. From everything I can see, delivering for gig economy companies like Doordash, Uber/Uber Eats, Instacart, Grubhub and others qualifies as qualified business income.
The Good News and Bad News of taxes for us self employed contractors.
Here's the good news. We get a lot of tax breaks from our self employed income. You can start with deducting your standard or itemized deductions.
Then you get your self-employment tax deduction AND your Qualified Business Income deduction. Those two add up to more than a quarter of your self-employed income.
Then if you had additional retirement savings or health insurance premiums, you have that much more that you can take off.
For income taxes, that really helps. A lot of drivers and gig workers can end up with extremely low income taxes thanks to these.
The bad news is, of course, self employment tax. Only one of these four items reduce that amount. And the other problem is, your self employment tax is on every dollar of profit. There are no tax brackets or standard deductions here.
But if you had a profit, you should definitely take advantage of the QBI and Self-Employment tax deductions. Then check with your tax pro to see if the others apply to you.
Tax Guide: Understanding Your Income
The following three articles help you understand what your real income is as an independent contractor.
Tax Guide: Understanding Your Expenses
The following eight articles help you understand the expenses you can claim on your Schedule C. Most of these are about your car, your biggest expense.
Filling Out Your Tax Forms
Once you understand your income and expenses, what do you do with them? Where does all this information go when you start filling out your taxes?