Year-End Tax-Planning and Deferred Income Tips for the Self-Employed
You Can Defer or Accelerate Both Income and Deductions
Freelancers and other self-employed taxpayers have several strategies available to them to help mitigate the cost of some taxes and to optimize their tax situations between current and future years. They can accelerate or defer income, and they can accelerate or defer deductions. But this means making some important decisions as the year draws to a close.
The Cash Method of Accounting
The timing of income and deductions depends on a self-employed taxpayer's accounting method, but the majority of self-employed workers and many small businesses use the cash method of accounting.
This means that you would include in your gross income money that you actually or constructively received during the tax year. "Constructively" means that income is credited or made available to you without restriction, such as a check you receive in December that you don't deposit until January. You could have deposited it when you received it. But if that check was postdated for January, your control of the money is subject to restriction.
According to the IRS, "Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations."
Deductions are somewhat different. You have no choice but to deduct them when you actually pay them, but you do have some flexibility as to when you pay them.
How Acceleration and Deferral Work
Accelerating income and deferring deductions increases the amount of income that's taxed in the current year. These can be useful strategies if your income falls into a lower tax bracket this year compared, but you expect you'll be in a higher bracket net year. You want as much income as possible to be taxed at this year's rates.
- Accelerating income means trying to bring in more money in the current year. Target income that's on the cusp so you might feasibly receive it by year's end.
- Accelerating deductions means spending money on expenses that will generate a tax deduction now rather than next year.
- Deferring income means postponing or delaying the receipt of certain revenues until a future year. Again, target income that's on the cusp so it might reasonably be postponed until next year.
- Deferring deductions means holding off on spending money on tax-deductible expenses until next year, or even later years when those deductions might be more advantageous to your tax situation.
These four tactics revolve around the proper timing of paid income and the use of deductions for tax-related purposes.
Deferring income or accelerating deductions decreases the amount of income that's taxed in the current year. This can be useful if your income falls in a higher tax bracket this year than you expect it will next year.
Income Acceleration Strategies, Benefits, and Risks
You can accelerate income by asking clients or customers to pay now. Call or write those who are behind in paying your invoices and try to collect sooner rather than later. Not only does this accelerate income, but it will also clean up your accounts receivable. You can also ask for larger up-front payments for projects that will span this year and next.
Accelerating income to this year could result in that income being taxed at a lower rate if you're in the 22% tax bracket this year and you expect that you'll be in the 24% bracket next year. But there's a caveat—tax brackets are based on the amount of your income, so taking in more this year could possibly push you up and right into of that 24% bracket this year.
It's something of a balancing act to get it right. You'll want to take in as much income this year as possible without pushing yourself into a higher tax bracket.
Income Deferral Strategies and Benefits
You might want to push your income into a lower tax bracket by deferring income to the following year if you're in the 24% bracket this year but expect to be in the 22% bracket next year. But, again, keep in mind that tax brackets creep up marginally each year to keep pace with inflation. The difference typically isn't huge, but tax brackets in each subsequent year generally accommodate slightly more income than they did the year before.
This can be another good reason to nudge some business income forward. When you reach the top of your uppermost tax bracket, why go over and pay a higher rate if you can defer that income to the next year and possibly be taxed at the same rate?
You might want to avoid trying to collect delinquent accounts as well until the calendar flips over. Send out collection letters in January instead of December to push some income into next year, or ask for smaller up-front payments for projects that span this year and next. Send out December invoices after Jan. 1.
Deduction Acceleration Strategies
Buy equipment this year instead of next year. Computers, software, vehicles, furniture, and other types of equipment are either depreciated over multiple years—which in itself is a form of deduction deferral—or they can be written off immediately using the Section 179 deduction. You must place the equipment in service in the current year if you use the Section 179 tactic.
Stocking up on office supplies is a good place to start if you need a few extra deductions this year to tweak your tax bill a little lower. Consider paying bonuses to your employees this year rather than after the first of the year, or make fourth quarter payroll taxes in December rather than in January.
Deduction Deferral Strategies
Put off investments in computers and other equipment until next year, and wait to stock up on supplies and other office necessities if possible. Consider paying bonuses to your employees in January instead of December.
Other Considerations: The Self-Employment Tax
You'll also want to keep an eye on the self-employment tax, which consists of two components: Social Security and Medicare. Typically, employers pay one half of these taxes on behalf of their workers, but you must pay both halves yourself if you're self-employed.
The 12.4% Social Security tax stops when a taxpayer's income exceeds $137,700 as of calendar year 2020. Annual income over this amount isn't subject to the tax, but your earnings start at zero again and the tax kicks back in on Jan. 1. Consider accelerating income if you're close to this threshold because anything you earn over this amount would be spared this tax whereas it might not be next year.
The Additional Medicare Tax
The Additional Medicare Tax is 0.9% on top of the 2.9% Medicare tax that's included as part of the self-employment tax. As of 2020, it applies when your income reaches $200,000 for single filers or head of household filers, $250,000 for married couples filing jointly, or $125,000 for married couples filing separately.
This additional tax is assessed on the combined Medicare wages and net self-employment income for both spouses if you file jointly with your spouse, so here's another word of warning: You might want to try to avoid accelerating too much income if you're considering an income acceleration strategy, potentially pushing yourself over the threshold to the point where this Additional Medicare Tax would come due.
Self-employed taxpayers whose incomes are near the thresholds for the Additional Medicare Tax might want to consider deferring income if it will keep them below the threshold for both this year and the next.
Review Your Retirement Plan
SIMPLE and 401(k) plans must be established or set up during the calendar year, even if the plan is funded retroactively next year. SIMPLE plans must be established before Oct. 1, and 401(k) plans must be established by Dec. 31.
Contributions to an IRA can be made up until April 15 of the following year, however, and SEP-IRA contributions can be made until April 15 or until Oct. 15 if you take an extension to file your tax return. You'll obviously want to make tax deductible contributions at the most opportune time.
Review Your Choice of Business Entity
Freelancers often work for themselves without any formal business structure. That might be a fine fit for your needs, but there are other possibilities as well. You might consider forming a corporation, a partnership, a limited liability company, or another formal structure.
Entrepreneurs who are working under one type of structure might want to review whether a different business structure could be more advantageous for them tax-wise because each has its own tax advantages and disadvantages. Consulting with a tax professional can help determine what's best for you.
For example, the Tax Cuts and Jobs Act provides for a Section 199A deduction, the Qualified Business Income (QBI) deduction, that allows certain businesses to shave 20% off their annual incomes beginning in 2018 and going forward. Many sole proprietorships and partnerships are eligible, as are S corporations and limited liability companies, but C corporations are not eligible—something to keep in mind if you would otherwise qualify for this deduction.
Review Estimated Tax Payments
You'll also want to set up a plan for tax payments that are due next year, because the IRS prefers to be paid as you earn. This includes the fourth estimated tax payment, which is due by Jan. 15. An extension payment, if any, is typically due by April 15, and the first estimated tax payment for the new year is also due on April 15.
Quarterly estimated tax payments are normally due by April 15, June 15, and Sept. 15 in the current year, and Jan. 15 of the following year for the three-month periods immediately preceding these dates. The June 15 payment was bumped back to July 15 in 2020, however, in response to the coronavirus pandemic.
These dates might be extended by a day or two in some years if the 15th of the month falls on a weekend or a national holiday.
Get a preliminary idea of what your tax liabilities will be this year so you have an idea of how much you should set aside for this year's and next year's taxes.
NOTE: Tax laws change periodically, so you should always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.
IRS. "Publication 334 (2019), Tax Guide for Small Business." Accessed Aug. 10, 2020.
Cornell Law School Legal Information Institute. "26 CFR § 1.451-2—Constructive Receipt of Income." Accessed Aug. 10, 2020.
IRS. "IRS Issues Guidance on Section 179 Expenses and Section 168(g) Depreciation under Tax Cuts and Jobs Act." Accessed Aug. 10, 2020.
Social Security Administration. "Contribution And Benefit Base." Accessed Aug. 10, 2020.
IRS. "Questions and Answers for the Additional Medicare Tax." Accessed Aug. 10, 2020.
IRS. "Types of Retirement Plans." Accessed Aug. 10, 2020.
IRS. "Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs." Accessed Aug. 10, 2020.
IRS. "Frequently Asked Questions / Individuals 2." Accessed Aug. 10, 2020.