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 is not going to try to get very extensive on all the other things you can or should do with your overall income tax. It is just an overview of the overall way that taxes are figured out.
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
The whole income tax process really boils down to the following 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 way to approach 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. You are adding your wages from any employment. You are adding in interest income and other types of income. And in this section you are adding in your self employment income.
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, you add them all together. If your self employed business (or businesses) amounted to a loss (more expense than income) you normally deduct 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.
Then you fill out the top half of Schedule 1. On that you have things like alimony, taxable refunds, unemployment compensation.
Also on that form is Business income. That's where you add in your total profit (or loss) from your Schedule C (or Schedule Cs). All of this income adds up to your TOTAL INCOME.
Step 2: Reducing Taxable Income Round 1.
Remember that this is the IRS we're talking about. They aren't keen on simplicity. On top of that fact, the form has been adapted and adjusted so many times in its life that it's not always going to make sense.
On Step 1, we talked about the first half of that Schedule 1 where you figure out the things that you ADD to your income.
The bottom part of that schedule is where you add up things that you can DEDUCT from your income. Student loan interest can come off here, so can health savings account deductions. One very important deduction that you put in here as a gig contractor is that you enter half of the Self Employment Tax that you calculated on Schedule SE.
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.
Step 3: Reducing Taxable Income Round 2.
See, this is the part that doesn't make sense to me. It's not important really, just illogical.
In this step you're making more adjustments. Here you are taking your deductions. It's really the same thing you were doing in Step 2, but just different things.
Why they don't just lump this in with Step 2, I don't know.
Here's where you include your deductions. This is the part where you either choose to itemize all those deductions like mortgage interest, charitable contributions, etc., OR take the standard deduction.
With the recent tax reform, the standard deduction amount was bumped up pretty high – $12,200 if single, $24,400 if married filing jointly. Which ever is best between these standard or itemized, you can take that off your total income.
A quick note just in case you've missed this other places. A lot of people are confused about this process because they think this is where they enter their business expenses. Your business expenses do not go in your deductions. They are part of your Schedule C.
There is one last part of this round that really applies for us. There is a Qualified Business Income deduction for small business owners. 20% of your self employed income can be taken here (so for our hypothetical person who earned $10,000, they can take $2,000 in deduction here)
So now you start with the Adjusted Gross Income (from the end of Step 2), subtract your deductions (itemized or standard), and then subtract your Qualified Business Income deduction.
NOW you have a number that represents your taxable income.
Note, if your deductions were greater than your income, you just put a zero in for taxable income. You do not put a negative number here.
Step 4: Figure out your income tax bill.
Now you figure out your income tax BILL. Dont' get confused here – this is not what you will owe and you haven't figured out a refund yet. This is where you figure out how much your actual income tax amount is.
Here you figure out what Uncle Sam gets to keep from your income.
The easiest way is to take that taxable income that you earned, and look it 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 $2,686 (2020 tax year).
The tax table and how it works
There's some misunderstanding about this process and about tax brackets.
Some folks think that once you reach a certain point, your income tax is now 12% ON ALL YOUR INCOME, or you reach the next point and now it's 22% ON ALL YOUR INCOME.
It doesn't work quite that way. For 2020 for a single filer it works this way:
- Your first $9,875 dollars are taxed at 10%
- For dollars $9,875 through $40,125, you're taxed 12%
- 22% on taxable earnings from 40,126 to $85,525
- 24% on taxable earnings from $85,526 to $163,300
- 32% on taxable earnings from $163,301 to $207,350
- 35% on taxable earnings from $207,351 to $518,400
- 37% on taxable earnings from $518,401 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
We'll play that out on another example, just that hopefully it illustrates so that it makes sense.
Say a single person had $50,000 in taxable earnings. That's the 22% bracket. But that doesn't mean they pay $11,000 in tax because they're in that bracket.
- The first $9,875 are taxed at 10%, or $987.50 in tax is owed.
- Dollars $9,701 through $40,125 are taxed at 12%. That means that $30,425 of their earnings are taxed at 12%, for $3,651.
- Only the last $9,575 are taxed at the 22% tax rate ($2,106)
- You add up the $987.50, $3,651 and $2,106 for a total of $6,774.50 of income tax.
See how that works?
At this point, you calculate your tax bill based on what you owe and what your tax bracket is. Hang on to that number. That's your Income tax but you aren't done yet.
Step 5. Non refundable credits are applied to your tax bill.
We're done with the income and deductions section. The tax amount has already been figured out. That's set.
What that means is we're not dealing with deductions any more. Deductions help you figure out what your tax bill is – they affect the taxable income.
Now we're at a section of the tax form that is about PAYING that tax bill.
So you'd think we would be looking at what you paid in already, right? Not yet. This is the IRS, right? We have another hoop to jump through first.
So now we get into tax credits. Tax credits act a lot like payments. There are a couple of different types of credits.
Most are called non-refundable. That means that if the credit is greater than the tax bill, no refund is generated.
Say your tax bill is $3,000 and you have non-refundable credits of $4,000. You don't get a refund for that extra $1,000. That $1,000 in credits just kinda disappears.
When the refundable credits are greater than your tax bill, it just means your tax bill is at zero. It doesn't go to a negative amount.
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.
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 7: Subtract your payments and refundable credits.
Did you or your partner have money withheld by an employer? That money goes in here.
Was there money that you sent in for estimated payments? That gets counted now.
Some 1099's will have money withheld such as gambling winnings or money taken from a retirement plan. Any money that was withheld and set to the government for your taxes gets added up here.
And then there are some credits that are considered refundable. Earned Income Credit, parts of the child tax credit, and parts of the American Opportunity credit for education costs are added in here. These are treated as payments just like all your withholding.
Add up all the payments and withholdings, and all of the refundable credits. Subtract that total from the adjusted tax bill you came up with at the end of Step 6.
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, now you have to pay the rest.
That's it, in an oversimplified but still wordy nutshell. If you were able to follow all of that, you get a better idea how your self employment income fits in with any other income and how the taxes come out like they do.
If you had a lot of credits, especially because of having children, or you had a lot of money withheld from other jobs, you may be looking at getting a refund or having a minimal amount to pay in.
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.
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. Understanding how your self employment income will impact your taxes will help figure out what to add.
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?