6 Things Every Freelancer Should Know About Money, According to an Accountant

published Nov 7, 2020
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Credit: Anna Spaller

The pandemic has changed the way Americans work. According to research from Stanford University, 23 percent of the United States labor force now works remotely full-time, while another 33 percent aren’t working at all due to the impact of the lockdown recession. And more and more people have pursued freelance work, whether it be as contractors, consultants, or business-owners themselves. 

In fact, a new study from Upwork states that 59 million Americans are now freelancing, representing 36 percent of the U.S. workforce—an eight percent increase since 2019. And while some workers have opted to go freelance this year for the flexibility, independence, and earning potential it offers, others have had no choice but to look for side gigs and other forms of self-employment to supplement their income as the pandemic wreaks havoc on the economy. 

If you are one of the many full-time workers turning to freelance work, you likely have a lot of questions. You also might not be fully aware of what this means for you taxwise. Along with self-employment tax rates and retirement plan options, some freelancers aren’t privy to the fact that they’re expected to pay estimated state and federal taxes before filing their yearly returns.

To help improve your financial health as a freelancer, we asked accountant Jonathan Medows of New York City-based accounting firm Medows CPA to share some of his insight. From expenses you can write-off to tips on how to prepare for back taxes, here’s what a financial expert says you should know as a freelancer.

Freelancers are taxed differently than employees.

When you work for yourself, you’ll pay more taxes than if you worked for an employer. “Along with federal and state income taxes, and any other taxes unique to your location, you will pay a self-employment tax,” Medows explains. “This is essentially the equivalent of a social security tax, except when you work for someone, they match your social security benefits, and work for yourself you pay for both.” 

According to the IRS, the self-employment tax rate is 15.3 percent, 12.4 percent for social security and 2.9 percent for Medicare, compared to the 6.2 percent employees pay. Translation: Freelancers pay more than double the amount of social security taxes, in the form of self-employment tax. Keep this in mind as you’re pricing your rates, and budget accordingly.

Credit: Joe Lingeman

You can write off certain expenses as tax deductions.

Medows says the flipside of self-employment tax rates is that freelancers can claim certain tax deductions that traditional employees can’t. “If you work from home, you’ll be able to deduct part of your rent or mortgage payment, or an area you use exclusively for work, under the home office deduction,” he explains. “There are also deductions for utilities, office supplies, travel expenses, insurance premiums, and in some cases, tax preparation fees.” 

To keep track of your freelance expenses throughout the year, Medows recommends downloading user-friendly accounting software, such as Quickbooks or Xero, to manage your finances regularly, or if you don’t want to pay for software, maintaining a spreadsheet like Google Sheets on your computer with all your work-related costs. It can take time to find the system that works best for your needs—what matters is that you stay diligent and organized, and track every invoice, expense, and investment.

You can contribute more to your retirement plan than people who are company employees.

There is an assortment of retirement plan options for self-employed workers, since freelancers won’t have access to a work-sponsored company retirement plan, like a 401k. “The most popular retirement plan options for the self-employed are Solo 401Ks and Simplified Employee Pension IRAs (SEP IRA),” Medows explains. “And both options allow self-employed people to make larger retirement plan contributions than traditional employees.” Additionally, Medows says that every dollar you contribute to a Solo 401k or SEP IRA is deductible from your income, so you can save for retirement while lowering your tax bill. If you’re unsure which type of retirement plan is right for you, consult an accountant or check out a breakdown of the different options on the IRS’s website

State and federal taxes aren’t withheld from your earnings. 

According to Medows, the biggest problem he sees freelancers face when filing their taxes is not anticipating owing taxes to the state and IRS. “Since taxes from your freelance income aren’t withheld, self-employed people are expected to pay whatever taxes they owe for the year by the tax return filing date (usually April 15),” he says. “IRS Form 1040 ES allows you to calculate your estimated taxes ahead of time, so you can pay them back on a quarterly basis throughout the year, and avoid being hit with a big bill when you file your annual tax return.” 

As a rule of thumb, Medows recommends putting at least 30 percent of every freelance check you receive into a separate savings account, to ensure you can cover any state and federal taxes you might owe before filing your return. 

Payment plans are available if you can’t pay back taxes right away.

Fortunately, Medows says the IRS offers payment plan agreements if you aren’t able to pay off all your back taxes right away. “There’s no reason to hide from the IRS no matter what you owe,” he says. “The IRS recently announced a number of changes designed to help taxpayers, especially ones impacted by COVID-19, settle their tax debts.” According to the IRS, this includes allowing certain qualified individual taxpayers who owe less than $250,000 to set up installment agreements without providing a financial statement or substantiation if their monthly payment proposal is sufficient.

Credit: Minette Hand

Don’t wait until the last minute to deal with your taxes.  

Above all else, Medows says the most important thing a freelancer can do for themselves financially is to stay on top of their taxes daily. “Use accounting software or spreadsheets to keep track of your expenses, file and pay estimated taxes, and if necessary, hire an accountant,” he advises. This also means hanging on to every single one of your business-related receipts, and potentially opening a bank account based solely on your freelance expenses, so you can track them separately. “If you’re self-employed, you should be tracking your expenses every day, not just quarterly,” he says. “Waiting until you file your annual tax return won’t yield optimal results.”