Year-End Tax-Planning Tips for Freelancers and the Self-Employed
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 have some decisions to make as the year draws to a close.
Certain strategies can help mitigate the cost of some taxes and optimize your situation between current and future years. They include accelerating or deferring income, and accelerating or deferring deductions.
The Cash Method of Accounting
The timing of income and deductions depends on a self-employed taxpayer's accounting method. "Most individuals and many small businesses use the cash method of accounting," according to the IRS. You would include in your gross income money that you actually or constructively receive during the tax year.
"Constructively" means income that "is credited to your account or made available to you without restriction," according to the IRS. "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."
Income is constructively received in December if you receive a check that month but don't deposit it until January. Sitting on it for a while was your choice—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 limitations. This makes it January's income.
You must deduct expenses when you actually pay them.
Acceleration and Deferral—How They 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 to what you expect it will be next year.
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.
- Accelerating income means trying to bring in more money in the current year. Target income that's on the cusp so it might feasibly be postponed until next year.
- 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.
- 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.
These four tactics revolve around the proper timing of paid income and the use of deductions for tax-related purposes.
Income Acceleration Strategies, Benefits, and Risks
Ask clients to pay now. Call or write those who are behind in paying your invoices. Not only does this accelerate income, but it also cleans 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 percent tax bracket this year and you expect that you'll be in the 24 percent 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 out of that 22 percent bracket.
So, 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.
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 percent bracket this year but expect to be in the 22 percent bracket next year.
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 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 this tactic.
If you need a few extra deductions this year to tweak your tax bill lower, stocking up on office supplies is a good place to start. 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-percent Social Security tax stops when a taxpayer's income exceeds $132,900 as of 2019. Consider accelerating income if you're close to this threshold because anything you earn over this amount would be spared this tax.
The Additional Medicare Tax
An additional Medicare tax is 0.9 percent on top of the 2.9-percent Medicare tax that's included as part of the self-employment tax. 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 may 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 October 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 October 15 if you take an extension. 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 just fine for your needs, but there are other possibilities as well, such as 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.
For example, the Tax Cuts and Jobs Act provides for a Section 199A deduction that allows certain businesses to shave 20 percent 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 want to set up a plan for tax payments that are due next year. 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.
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.
Tax laws change periodically and 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.