You've done all the work. You've added up your income and 1099's for your self employed work. And, you've figured out your expenses. You now know what your taxable profit is.
How does this impact your income taxes?
We just talked about your self employment tax. Now we're going to dive into what you do with it on your income tax form (1040).
These two may not be the only taxes you have to deal with. Most states also have a state income tax and there are a lot of local taxes out there as well. I can't begin to dive into all those.
This article doesn't intend to extensively cover your entire income tax form. The purpose here is to overview how taxes work and how your independent contractor income plays into that.
Talk to your tax professional to get the particulars on the best way to handle your own overall tax picture.
Walking through the 1040 Form for Income Tax
In a nutshell, income taxes are a process that asks three questions:
- How much did you earn?
- What is your tax bill?
- What have you already paid in?
The schedule C process was all about determining what your earnings were for your business. You do that process along with adding in any other income, and once that's all done, you can move to the next step of figuring out the tax bill.
And then from there you determine what has been paid and if you still have to pay more or if you get anything back.
If you walk through the 1040 form, you can get a feel for how it all works out and how everything is added up. I think that's the easiest approach for this topic.
It's impossible for me to answer questions like “what will I owe?” because as you see in all these steps, there are a lot of variables. I want to keep this as simple as possible and hopefully not OVER simplify it.
Step 1: Add up all the income.
Here's where you are putting together all of your sources of income. Add up your W2 Employment wages. Add in other types of income like interest, investments and retirement. Also in this section you add the self employment income from your Schedule C.
This is why I say the Schedule C is really more like a W2 than your 1099. It's the bottom line from the Schedule C that you add to everything else. It is only the PROFIT that you are adding.
If you had multiple schedule C's, add them all together. If you had a loss (more expenses than income) you subtract that loss from other income.
You are getting a total picture of your income. Wages are added up. Interest and investment income are added in.
The smaller details: How your Schedule C income gets moved to your 1040 form.
We'll talk about a lot of steps that happen with tax forms and the like. If you're using a software program like TurboTax (affiliate link) the program automatically walks through it. Sometimes it helps to know these details, as you get a better idea what all is happening.
You don't immediately add your Schedule C income to form 1040. Instead, you put them on a form called Schedule 1. That's a form where you also list other types of income such as alimony, taxable refunds, unemployment compensation and others.
Your profit (or loss) goes on this form as business income.
The total of all of this income is then moved over to your 1040.
Add up all of your wages, retirement, interest and other income (including your business income). The IRS calls this total income. It's a subtotal.
Step 2: Reducing Taxable Income Round 1.
This is what you could call the pre-deduction deduction stage.
Remember that this is the IRS we're talking about. They aren't keen on simplicity. I think the form gets complicated after all the adjustments and changes over the years.
Remember the income part of Schedule 1 we talked about? There's a second half. That half contains income adjustments. They include things like:
- Educator expenses
- Health Savings Account contributions
- Alimony paid
- Individual Retirement Account contributions
- Student loan interest paid
- Tuition paid.
- 1/2 of your self-employment tax
- Contributions if you have a self-employed retirement account
- Premiums for self-employed health insurance.
The purpose of all of these adjustments is to let you take some special tax deductions regardless of whether you itemize or take the standard deduction.
Add up all the deductions on this lower part of Schedule 1. Subtract that total from your total income that you figured out earlier, and that is your Adjusted Gross Income, or AGI.
This still isn't your taxable income. There's another step.
Step 3: Reducing Taxable Income Round 2 (Tax Deductions).
This step is pretty much the same thing as Step 2.
The only real difference here is that what happened in Step 2 brought down your Adjusted Gross Income. That's important because a lot of government programs use AGI as a qualification. What happens here doesn't affect your AGI, but does bring down your taxable income.
Now we get into actual tax deductions. These are the last adjustments that determine your taxable income.
Here's where you choose to itemize or take the standard deduction.
With the recent tax reform, the standard deduction amount was bumped up pretty high – $12,550 for single filers and $25,100 for married (2021 tax year).
This is important to remember from the income section. Schedule C income is added in Step 1: Income.
Why is this important? Your business expenses go on Schedule C. They do not go in itemized deductions. What that means is, you can claim miles and expenses no matter whether you itemize or take the standard deduction.
For the 2021 tax year, a single person can write off up to $300 in charitable contributions without itemizing ($600 for a married couple).
Line 13 of 2021 form 1040 is an important one for independent contractors. It's called a Qualified Business Income tax deduction. You can write off 1/5 of your self-employed income (even if taking the standard deduction.
After subtracting these, we have your TAXABLE income. Your income tax is based on this. Note: you do not put a negative number here, only a 0 if you had a loss.
Step 4: Figure out your income tax bill.
Now you figure out your income tax BILL.
Do not confuse this with what you pay in (or what you get as a refund). That comes later.
The tax bill is the part that Uncle Sam gets to keep out of what you made.
Income tax is a percentage of your taxable income. That means all those adjustments above make a difference on your tax basis.
However, the formula is complicated. Instead of making you figure it out, the IRS makes it easy by letting you look your tax up in the IRS tax tables.
Say for example you were single and your total taxable income once everything was figured in was $24,000. The tax bill according to the table is $2,684 (2021 tax year).
Don't get freaked out by tax brackets.
There's some misunderstanding about this process and about tax brackets.
People are afraid of getting into the next tax bracket because they think their entire taxable income will now be taxed at that higher rate.
For instance, at $40,526, a single person moves into the 22% tax bracket. The common misunderstanding here is if you cross that threshhold, ALL of your income will be taxed at 22%. Fortunately, it doesn't work that way.
Taxes are calculated in stages. The tax rate for the first several dollars is 10%. Then if you make more, tax on that additional money is 12% until you get to the next threshhold.
If you are single in 2021, it works like this:
- Your first $9,950 dollars are taxed at 10%
- For dollars $9,951 through $40,525, you're taxed 12%
- 22% on taxable earnings from 40,526 to $86,375
- 24% on taxable earnings from $86,376 to $164,925
- 32% on taxable earnings from $164,926 to $209,425
- 35% on taxable earnings from $209,426 to $523,600
- 37% on taxable earnings from $523,601 and up.
For married couples, the levels here are doubled on most, and for married head of household it's somewhere in between the two.
Here's an example
Maybe taking a look at an example will help.
Say a single person had $50,000 in taxable earnings. That's the 22% bracket. However, they won't pay a $11,000 tax bill.
- The first $9,950 are taxed at 10%, for $995. That amount will never change no matter what tax bracket they are in.
- The tax rate for the next $30,575 is 12%. That too never changes. That comes out to $3,669
- Only the last $9475 are taxed at 22%. That adds up to $2,085
- Add those three up and your total tax bill is $6,749.
See how that works? Ultimately that's right about 13.5% of taxable income, which is quite a bit lower than 22%.
After you figured out your profit (Schedule C) you used that profit to determine your self-employment tax. We talk more about Schedule SE and how self-employment tax is calculated in this part of this tax guide.
Now it's time to do something with that.
HERE is the point on the tax form where you're adding that self employment tax to your total tax bill.
Why wasn't this just added way back at the beginning? It has to do with the non-refundable credits. Those credits are not meant to be applied to self employment tax.
The thing is, a W2 employee doesn't get their Social Security or Medicare lowered when the non-refundable credits are greater than the tax bill. Letting those non-refundable credits apply to self employment tax would do exactly that.
You add your self employment tax to the total you came up with at the end of step 5 and now you have your new total tax bill. We'll call it an adjusted tax bill.
Step 5. Applying non-refundable credits
We're done with the income and deductions section. We've figured out your income tax bill.
Like I said earlier, that's not the same thing as what you owe (or get back). But at least now we're at a point where we're figuring out how that's paid for.
So you'd think we would be looking at what you paid in already, right? Not yet. This is the IRS, right? We have more hoops to jump through.
The first hoop is to look at non-refundable tax credits.
People confuse tax deductions with tax credits. A tax deduction reduces your taxable income. That's all done with.
A tax credit is something you can treat like a payment on your tax bill. Every dollar of tax credits reduces your tax bill. Most taxes are non-refundable.
There's a non-refundable part of the child tax credit you can take here. And there's two pages of other credits on Schedule 3.
Some non-refundable credits include things like:
- Childcare credits
- Education credits
- Electric Vehicle and alternative energy credits
- Adoption credits
And a whole list of others.
What's happening here is you're adding up those credits and using them to pay part or all of your income tax bill.
Non refundable here means if your total credits are more than your income tax bill, you won't get a refund. Instead, your income tax bill is now $0. It doesn't go to a negative amount. The additional credits just kind of go away.
Step 6: Add your self employment tax.
In the previous article we talked about figuring out your self employment tax. At the end, I said hang on to that number.
Here's where you need it. HERE is the point on the tax form where you're adding that self employment tax to your total tax bill.
It's a little more involved, of course. Self-Employment tax is added to line 4 of Schedule 2. Schedule 2 is a form that lists additional taxes beyond income tax. You add up all those taxes, and now add them to what's left of your income tax bill.
The new total is your total tax.
It seems weird that this wasn't done earlier, like in Step 4, doesn't it? There's a reason that it happens now.
The IRS doesn't want you to use those non-refundable credits from Step 5 to pay for anything but income tax.
When you think about what Self-Employment tax is, though, you can maybe understand why. That's your version of Medicare and Social Security taxes.
See, an employee has those taken out of their paycheck immediately. They can't use any of those credits to pay those taxes for them. It makes sense that we can't either.
Step 7: Subtract your payments and refundable credits.
Did you or your partner have money withheld by an employer? That money goes in here. Did you send in estimated quarterly payments? Those go here.
Some 1099's will have money withheld such as gambling winnings or money taken from a retirement plan. All of that goes here as well.
Now we get to the refundable credits. These are different from non-refundable credits. Refundable credits are just like cash. They can be applied to your self-employment tax just like withholding and other payments you sent in.
And you can get a refund if they are more than your total tax bill. Thus, the name refundable.
Refundable credits include Earned Income credit, part of the child tax credit, American Opportunity credit (for college tuition) and a few others.
Add all of these up and you have your total payment.
Step 8: Pay in or get a refund.
Here's where you can now answer the question, do you owe or do you get a refund?
If the payments and refundable credits were more than your tax adjusted bill, you get a refund for the difference. If the payments and refundable credits weren't enough to pay that adjusted tax bill, you pay the difference.
A lot of people think that it's impossible to get a refund if all your money was made delivering for Doordash, Uber Eats, Grubhub, Instacart or any of the many others. Thanks to the Earned Income Credit, Child Tax credits and many others, that's not necessarily true.
However, if you made a substantial profit but didn't pay anything in and don't have much for credits, you could be looking down the barrel of a hefty tax bill.
That's it, in an oversimplified nutshell.
If you were able to follow all of that, you have a better idea how your self employment income fits in with any other income. Maybe you have a better idea how taxes work out the way you do.
Understanding this process can help you understand how to plan for future needs as well. Knowing what your credits might look like can help you tremendously. You'll get an idea if you need to save, or how much you need to save.
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?