Year-End Tax-Planning Tips for Freelancers and Self-Employed Persons
You can defer or accelerate both income and deductions
Freelancers and other self-employed taxpayers have several tax planning strategies available to them, but this means they typically have some decisions to make before the year ends. The following strategies can help mitigate the cost of certain taxes and optimize your tax situation between the current and future years. They fall into four basic categories: accelerating or deferring income, and accelerating or deferring deductions.
Acceleration and Deferral—How It Works
Accelerating income means that you'll try to bring in more income this year, particularly income that's on the cusp because it might feasibly be postponed until next year. Similarly, accelerating deductions means spending money on expenses that will generate a tax deduction now.
Deferring income means postponing or delaying the receipt of certain revenues until a future year. Deferring deductions means holding off on spending money on tax-deductible expenses until next year or later years when those deductions might be more advantageous to your tax situation then.
Accelerating income and/or deferring deductions functions to increase the amount of income that's taxed in the current year. This may be a useful strategy if your income falls into a lower tax bracket this year compared to what you expect it will be next year. Deferring income and/or accelerating deductions functions to decrease the amount of income that's taxed in the current year, and this can be useful if your income falls in a higher tax bracket this year than you expect it will next year.
These four tactics revolve around the proper timing of paid income and the use of deductions for tax-related purposes.
Methods of Accounting
The timing of income and deductions depends on a taxpayer's accounting method. According to the IRS, "Most individuals and many small businesses use the cash method of accounting," so we'll focus here on the rules for cash method self-employed taxpayers.
Under the cash method of accounting, "You include in your gross income all items of income you actually or constructively receive during the tax year," according to the IRS. "You deduct expenses in the tax year in which you actually pay them...However, you may not be able to deduct an expense paid in advance. Instead, you may be required to capitalize certain costs."
So self-employed persons will report income that is actually or constructively received during the tax year. "Constructively" means income that "is credited to your account or made available to you without restriction. You need not have possession of it...Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations."
In plain English, if you receive checks in late December and don't deposit them until January, that income is constructively received in December when they were made available to you. Sitting on them for another month was your choice—you could have deposited them. By the same token, if a client sent you a check postdated for January, your control of that money is subject to limitations so that makes it January's income.
Income Acceleration Strategies for the Self-Employed
- Ask clients to pay now. Call or write to clients who are behind in paying your invoices. Not only does this accelerate income, but it also cleans up your accounts receivable.
- Ask for larger up-front payments for projects that will span this year and next.
If you're in the 15-percent tax bracket this year, and if you expect that you'll be in the 25-percent bracket next year, accelerating income to this year could result in that income being taxed at a lower rate. But there's a caveat—tax brackets are based on the amount of your income so taking more income this year could potentially push your income up and right out of that 15-percent bracket. It's something of a balancing act to get it right. You'll want to take as much income this year as possible without pushing yourself into that higher tax bracket.
You'll also want to keep an eye on the self-employment tax. This tax consists of two components: Social Security and Medicare. Typically, employers pay one half of these taxes on behalf of their workers.
If you're self-employed, however, you must pay both halves yourself.
The 12.4-percent Social Security tax stops when a taxpayer's income exceeds $127,200 as of 2017. Consider accelerating income if you're close to this threshold because anything you earn over this amount would be spared this tax.
An additional Medicare tax of 0.9 percent—on top of the 2.9-percent Medicare tax that's included as part of the self-employment tax—applies when your income reaches $200,000 for single filers or head of household filers, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. If you file jointly with your spouse, this additional tax is assessed on the combined Medicare wages and net self-employment income for both spouses. So here's another word of warning: If you are considering an income acceleration strategy, you may want to try to avoid accelerating too much income, pushing yourself over the threshold to an income where this additional Medicare tax would apply.
Income Deferral Strategies for the Self-Employed
- Send out collection letters in January instead of December to push some income into next year.
- Ask for smaller up-front payments for projects that span this year and next.
If you are in the 25-percent bracket this year and expect to be in the 15-percent bracket next year, you could push your income into a lower tax rate by deferring income to the following year. Self-employed taxpayers whose incomes will be near the thresholds for the additional Medicare tax may want to consider deferring income if it will keep them below the threshold for both this year and the next.
Strategies that Involve the Timing of Deductions
Self-employed persons report deductions that are actually paid during the year, although some deductions can be paid after the year ends. For example, contributions to an IRA can be made up until April 15 of the following year, and SEP-IRA contributions can be made until April 15, or until October 15 if you take an extension. For all other deductions, however, the expenses would have to be paid during the calendar year.
Deduction Acceleration Strategies for the Self-Employed
- 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 this tactic.
- Stock up on office supplies. If you need few extra deductions this year to tweak your tax bill lower, this is a good place to start.
- Consider paying bonuses to your employees this year.
- Consider making 4th quarter payroll taxes in December rather than in January.
Deduction Deferral Strategies for the Self-Employed
- Put off investments in computers and other equipment until next year.
- Wait until next year to stock up on supplies and other office necessities if possible.
- Consider paying bonuses to your employees in January instead of December.
Review your Books and Your Bookkeeping System
Review the financial health of your business with your accountant. Many accountants will help you analyze your profit and loss statement and your balance sheet to identify year-end tax strategies that are appropriate for your business.
Entrepreneurs should also evaluate whether their current accounting system is sufficient for their needs. There are plenty of small business accounting software options available if your current system doesn't have all the features you want or require.
Review Your Retirement Plan
Self-employed people have several options when it comes to retirement plans, including SEP-IRAs, SIMPLE IRAs, and 401(k) plans. 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 October 1, and 401(k) plans must be established by December 31. Review your current plan to see if it and your funding levels are appropriate for your needs for the year to come.
Review Your Choice of Business Entity
Freelancers often work for themselves without any formal business structure, commonly referred to as being "unincorporated." That might be just fine for your needs, but there are other possibilities as well, such as forming a corporation, partnership, limited liability company, or another formal structure. There's no one-size-fits-all answer. Entrepreneurs who are working under one type of structure may want to review whether a different business structure might be more advantageous for them tax-wise.
Each business structure has its own tax advantages and disadvantages. It may be especially strategic to review your business structure if your finances or tax exposure is changing significantly.
Review Estimated Tax Payments
You'll want to set up a plan for tax payments due next year. This includes the 4th estimated tax payment, which is due by January 15. The extension payment, if any, is typically due by April 15, and the first estimated tax payment is also due on April 15. This 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.