Well, the holidays are upon us and no matter how you choose to celebrate, for many this time of year represents a welcome respite from the day to day doldrums of work. And while your mind may be more occupied with gift ideas, holiday cheer, and pondering the age old question of “who actually enjoys eggnog?”, for freelancers there is still work to be done, particularly when it comes to preparing for tax season, and here are three easy steps freelancers MUST take by December 31st 2021, if they want to lower their taxes.
Contribute to a Retirement Plan
As a freelancer, you’re left to your own devices when it comes to planning for retirement. I’d refer you to our previous blog on the retirement options available, but in short there are two options commonly deployed by freelancers that can also help you reduce your taxable income: SEP IRA and a Solo 401K.
When you contribute to a SEP IRA or a Solo 401K you’re using what’s referred to as “pre-tax” dollars. This means that the amount you’ve contributed to these accounts is directly deducted from your taxable income: you don’t pay taxes on the money this year, you will when you use it in your retirement
For example: say I earn $30,000 this year from freelancing activities and have a SEP IRA I contribute $5,000 to over the course of the year. When it comes time to calculate my taxes at the end of the year, the starting income I use to calculate my taxes is automatically reduced by the $5,000 I contributed to my SEP IRA.
Now be aware that the timing of the contribution is key to benefit from the tax deduction..
- For a Solo 401K, to recognize this deduction on your 2021 tax return, you MUST contribute to your plan before December 31st, 2021.
- For SEP IRAs you can actually include contributions all the way up to your filing date. This means I could make a contribution on the day before I file and still include the deduction on my 2021 taxes.
It’s also important to note, the IRS places the following limits on how much one can contribute to their retirement account in a given period:
- SEP IRA: 25% of your 2021 net earnings(capped at $58,000)
- Solo 401K: $19,500 plus 25% of your net earnings (capped at $58,000).
(Quick Note: A Roth IRA is another popular type of retirement account but as it uses post-tax dollars, contributing to it will not impact your taxable income in the current year).
Make that Big Purchase
Maybe it’s a new desk. A new van. Or pre-purchasing supplies. Whatever it may be, odds are there’s a big purchase on the horizon you’ll need to drive your business forward. If that’s the case, the timing of that purchase can actually have a notable tax effect.
This is due to the fact business expenses and large business purchases are tax deductible via IRS Schedule C, which means they won’t be included in your taxable income. So if there’s a significant purchase you know you’re going to make soon or maybe you’ve just been going back and forth about treating yourself to that ergonomic, posture-correcting office chair or that second adjustable monitor, doing so before the end of the year means you can write it off from your 2021 taxes.
Adjust Your Billing
For the vast amount of freelancers, bookkeeping and taxes are handled on a cash basis meaning the reporting of income is dependent on receiving the money from a client. Because of this, a freelancer’s billing process can serve as a valuable tool for minimizing taxable income.
How, you might ask? Well, income received on or BEFORE December 31st 2021 is taxable income which will be reflected on your 2021 tax returns. Income received on or AFTER January 1st will be considered taxable income for the 2021. By being conscious of this December 31st date, you can identify income that is teetering between being remitted in this year or the next and utilize the billing processes to lower taxable income by attempting to ensure money isn’t received until after the end of the year.
For example: Say I have a client who I complete work for on December 20th. From my experience I know it usually takes them two weeks to send me a check. By waiting a few days to invoice them, I can increase the likelihood that the check is received in January and will be included in subsequent year earnings as opposed to current year income.
While identifying income on the cusp of multiple calendar years and adjusting your billing accordingly can be an effective strategy for lowering your current year taxable income, I’d be remiss if I didn’t qualify this with a disclaimer: you should never elect to delay or accelerate billing if it will ultimately inhibit your ability to actually receive payment from a client. Additionally, if you’ve performed services for a client and they’ve already paid you, there’s no way to defer that income, it has to be included in your tax filings. Failure to do so can get you in big trouble with the IRS.
Before You Settle in for the Holidays
With the trappings of the holidays just over the horizon, the warm embrace of culinary over-indulgence and the appeal of coasting through the end of the year can be enticing. Yet, with a little effort you can ensure you’re positioned well come tax time and set your business up for success in the new year.
But know this, while the above are a few common strategies for reducing taxable income, there are many other ways to ultimately reduce the check you’ll write to Uncle Sam. These can include contributing to your Health Savings Account or making a charitable donation. So understand how taxes are calculated, use the resources available (shameless plug to our extensive library of articles on our blog or freelancer’s handbook), and be a little creative, and you too can reap some major tax benefits.