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Most-Overlooked Tax Deductions & Credits for the Self-Employed

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Most-Overlooked Tax Deductions & Credits for the Self-Employed

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If you've recently gone into business for yourself, see how the tax laws can work for you.

Thanks to the pandemic and the "Great Resignation," more people are leaving their traditional jobs and venturing out on their own. Self-employment can lead to more money, flexibility, control, or personal satisfaction, but it can also come with new financial headaches you probably didn't have to deal with as an employee. After all, the success of your business is in your own hands, which can create a lot of extra pressure and anxiety.

Fortunately, there are some tax deductions and credits available for self-employed people that can help dial down the stress and improve your bottom line. And when you're on your own, you need to take advantage of whatever assistance is available. That includes help lowering your tax bill. But sometimes the hard part is simply making yourself aware of the tax breaks available so you can claim them on your tax return. With that in mind, now that you're self-employed, check out these often missed ways to make the tax laws work for you. You'll be happy you did when it's time to file your return.

Home-office deductions

Whether you're fully self-employed or do some freelancing in addition to your job as an employee, if you work at home the government might subsidize what are generally considered personal expenses.

The key to the home-office deduction is to use part of your home or apartment regularly and exclusively for your moneymaking endeavor. Pass that test and part of your utility bills and insurance costs can be deducted against your business income. You can also write off part of your rent or, if you own your home, depreciation (a noncash expense that can save you real money on your tax bill).

Many work-at-home taxpayers skip this break, either because they don't know about it, are afraid claiming it’ll trigger an audit, or are put off by the recordkeeping hassle necessary to back up the deduction if challenged. However, the IRS has come up with a simplified method allowing taxpayers to deduct $5 for every square foot that qualifies for the deduction. If you have a 300-square-foot home office (the maximum size allowed for this method), your deduction is $1,500. You get this tax-saver every year you have a qualifying home office.

Business use of a vehicle

There's a tax deduction waiting if you drive your own car for business... and it isn't just for Uber or Lyft drivers. Any self-employed person who makes deliveries, drives to a client's location or otherwise uses a personal vehicle for work-related purposes can claim this deduction.

There are two ways to calculate the deduction – you can use the standard mileage rate or your actual car expenses. If you use the standard mileage rate, you can deduct 56¢ for every mile driven for business in 2021 (58.5¢ for 2022). Make sure you keep good records of the dates and miles you drive for work… and don't include driving for any personal trips or errands.

With the actual expense method, you add up all your car-related expenses for the year – gas, oil, tires, repairs, parking, tolls, insurance, registration, lease payments, depreciation, etc. – and multiply the total by the percentage of total miles driven for business reasons. For example, if your total annual car costs are $5,000 and 20% of your miles were for business, then your deduction is $1,000 ($5,000 x .2).

Health insurance premiums

Although medical expenses are deductible, relatively few taxpayers really get to deduct them. First, you must itemize to get this tax break (and most taxpayers don’t). Second, you get a deduction only to the extent your expenses exceed 7.5% of your adjusted gross income.

But there's a big exception for the self-employed. You can deduct what you pay for medical insurance for yourself and your family, whether or not you itemize and without regard to the 7.5% threshold. You don't qualify, though, if you're eligible for employer-sponsored health insurance through your job (if you have one in addition to your business) or your spouse's job.

Plus, if you continue to run your businesses after qualifying for Medicare, the premiums you pay for Medicare Part B and Part D, plus the cost of supplemental Medicare (medigap) policies or the cost of a Medicare Advantage plan, can be deducted as health insurance premiums without having to itemize.

Social Security taxes you pay

Instead of having payroll taxes taken out of their paychecks like regular employees, you must pay a special 15.3% tax if you're self-employed. The overall tax actually consists of two parts – a 12.4% Social Security tax and a 2.9% Medicare tax. The good news is you get to write off half of the self-employment tax you pay. Plus, you don't have to itemize to take advantage of this deduction.

There are some limits on the tax that help, too. You only have to pay the 15.3% tax if you have net earnings of $400 or more from self-employment during the year. Also, for 2021, the maximum amount of self-employment income subject to the 12.4% Social Security tax is $142,800 ($147,000 for 2022).

Retirement tax shelters and credits

Once you start working for yourself, the door opens wide to tax-sheltered retirement plans. Unlike employees, whose options are pretty much limited to whatever their employer offers and an IRA, self-employeds can contribute pretax money to a simplified employee pension (SEP) or a solo 401(k), both of which have higher annual limits than regular individual retirement accounts. (Oh, and you can still have an IRA, too.)

You may also get a tax credit for contributions to your retirement plan if your income isn't too high. It's called the Saver's Credit, and it can trim up to $1,000 off your tax bill ($2,000 for married couples). The credit is worth 50%, 20% or 10% of your contributions depending on your adjusted gross income. However, for the 2021 tax year, it's completely phased out for single filers with an AGI over $33,000 ($66,000 for joint filers). For 2022, the AGI threshold for singles is $34,000 ($68,000 for couples).

Covid-related sick and family leave credits

Self-employed people don't always get the same tax breaks other businesses are entitled to claim. But that's not the case with the Covid-related sick and family leave tax credits enacted to help businesses struggling during the pandemic. For the 2021 tax year, you can claim sick and family leave credits similar to credits allowed for other businesses if you were unable to perform services as a self-employed person due to certain COVID-19 related circumstances during the first nine months of the year.

Generally, you may be entitled to a tax credit if you're self-employed and were unable to work between January 1 and September 30, 2021, for one or more of the following reasons:

  • You or someone you were caring for was subject to a federal, state, or local quarantine or isolation order related to COVID-19;
  • You or someone you were caring for was advised by a health care provider to self-quarantine due to concerns related to COVID-19;
  • You were experiencing symptoms of COVID-19 and seeking a medical diagnosis;
  • You were exposed to COVID-19 or were waiting for results of a test or diagnosis;
  • You were getting a COVID-19 vaccination or taking someone else to get one;
  • You or someone you were caring for was recovering from an injury, disability, illness, or condition related to the vaccination; or
  • You provided certain coronavirus-related care to a son or daughter whose school or place of care was closed or whose childcare provider was unavailable for reasons related to COVID-19.

The credit amounts depend on various factors, such as the reason for missing work, when you missed work, and how long you were out.

Deduction for qualified business income

There's a relatively new tax deduction you may’ve heard about – it's called the qualified business income deduction (a.k.a., the Section 199A deduction). It's available for owners of S corporations, partnerships, LLCs and other "pass-through entities"… but did you know self-employeds operating as sole proprietors can also claim it? It's a tricky tax break with several special rules and restrictions, but the write-off is sizable if you can jump through all the hoops.

Generally, eligible self-employed people can deduct up to 20% of qualified business income (QBI) from their business. QBI is the net amount of income, gain, deduction and loss from the business included in your taxable income (minus capital gains and losses, certain dividends, interest income, wage income and a few other items). However, the deduction is subject to various limitations if your 2021 taxable income is $329,800 for joint filers, $164,925 for married taxpayers filing separate returns, and $164,900 for single and head-of-household filers. (For 2022, the threshold is $340,100 for joint filers and $170,050 for all other taxpayers.) One of the limitations phases out the deduction for high earners running certain types of businesses (e.g., health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or, in limited circumstances, any business where the principal asset is the reputation or skill of its employees).

Again, it's a complicated deduction… but one well worth looking into if you're self-employed.

Expensing

When you buy equipment for your business, you have two choices of how to share the cost with Uncle Sam.

The first is to depreciate the cost, deducting the expenses over the number of years the IRS figures is the "life" of the equipment. A computer has a life of five years, for example, so you can write off the cost over five years. But it's not as simple as claiming 20% of the cost each year. For that computer, for example, you'd deduct 20% of the cost in the year you put it into service, 32% in year two, 19.2% in year three, 11.52% in year four, 11.52% in year five and the final 5.76% in year six. (Don't ask why it takes six years to write off five-year property.)

Expensing (also known as the Section 179 deduction) lets you deduct 100% of the qualifying cost in year one. Is there any wonder why it's the choice of many self-employed taxpayers? For the 2021 tax year, up to $1.05 million worth of equipment is eligible for the immediate write-off of expensing ($1.08 million for 2022), although that amount is reduced if you place more than $2.62 million of new assets into service during any single year ($2.7 million for 2022).