If you’ve been following us for the past few months, you’ve heard us say many times that Lili’s tax tools are here to help you save time and money on your taxes. It does look great in an ad. But what looks even better is when we actually deliver on our promise. So, let us show you exactly what we mean.
Step 1. Sort and categorize all your transactions
Step 2. Download your Income & Expense Report from the Lili app
Go to Statement & Documents in the menu and download your annual Income & Expense Report
Step 3. Calculate your Net Earnings
Your Net Earnings are basically your profit as a freelancer. Pretty basic business stuff: revenue – expenses = profit.
If all the money you received in your Lili account comes from your freelance work, then your Net Earnings are immediately ready for you at the bottom of the form. If you’ve received money from friends and family or other sources, you should remove it first from your Total Income, and then deduct your Total Expenses.
This is where making sure you include ALL your business expenses from the year can save you some real $$. Because all your tax calculation start with your Net Earnings.
Step 4. Calculate your Self Employment Taxes
Self Employment taxes are simple (really it is, just stick with us): it’s a flat 15.3% on 92.35% of your Net Earnings. This rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare. (Note that you only pay the Social Security portion on the first $137,000 of your net earnings)
Now why 92.35%? Because half of your self-employment taxes (15.3/2 = 7.65) are deductible. So by removing 7.65% of your net earnings, you make sure you don’t pay taxes on money you’re allowed to deduct. (100 – 7.65 = 92.35)
So, let’s say you made $85,000 this year and imagine a couple of scenarios.
In SCENARIO 1, you accounted for $15,000 of business expenses, taking your Net Earnings to $70,000.
SELF EMPLOYMENT TAXES in SCENARIO 1
15.3% x (92.35% x $70,000)
15.3% x $64,645
In SCENARIO 2, you forgot some purchases you made throughout the year and therefore only accounted for $12,000 of business expenses, increasing your Net Earnings to $73,000.
SELF EMPLOYMENT TAXES in SCENARIO 2
15.3% x (92.35% x $73,000)
= 15.3% x $67,416
So by accurately keeping track of your business expenses in Scenario 1, you’ve already saved $424.
But, wait, it isn’t over. There’s even more savings down the line.
Step 5. Calculate your Income Tax
Step 5.1 – Adjusted Gross Income
Now that we’ve determine your Net Earnings and the taxes you owe as a professional freelancer, we can calculate your income tax, which is basically what you owe as an individual.
First step is to calculate your ADJUSTED GROSS INCOME (AGI)
AGI = NET EARNINGS – ABOVE THE LINE DEDUCTIONS
Only a few specific expenses qualify as Above the Line Deductions: contributions to a retirement account, health insurance premiums for individual plans, student loan interest, 50% of your self-employment taxes…
Let’s continue with SCENARIO 1 and say that this year you contributed $2,000 to an IRA, paid $3,000 in premiums for a health plan and $1,500 of student loan interest. Add to that 50% of your self-employment taxes ($9,891 / 2 = $4,946) and your ADJUSTED GROSS INCOME lands at
ADJUSTED GROSS INCOME in SCENARIO 1
$70,000 – ($3,000 + $2,000 + $1.500 + $4,946)
= $70,000 – $11,446
Step 5.2 – Taxable Income
The next step is to calculate your Taxable Income (TI)
TI = ADJUSTED GROSS INCOME – BELOW THE LINE DEDUCTIONS
Every other expense that qualifies gets deducted at this step as Below the Line deductions (charity donations, state and local taxes up to $10K, mortgage interest, unreimbursed medical expenses…)
The IRS also offers a simple option, which is to deduct a flat amount called the Standard Deduction. That amount depends on your filing status and changes slightly from year to year.
If the sum of your Below the Line deductions is lower than the Standard Deduction that corresponds to your filing status, you should just take the easy route and go with the Standard Deduction.
In our example, we’re going to be a single filer with $7,500 of Below the Line deductions, so we’re opting for the Standard Deduction, and we can now calculate our taxable income:
TAXABLE INCOME in SCENARIO 1
$58,554 – $12,400 =$46,154
Step 5.3 – Calculate your federal income tax.
Now that you know your Taxable Income, all you need to do is to take a look at the yearly tax bracket tab and a quick trip back to algebra class. So with a taxable income of $45,745 as a single filer, you land in the 22% bracket.
Now keep in mind the US tax system is progressive, meaning you won’t pay 22% on ALL your taxable income, only the top dollars. You only pay the tax percentage that corresponds to each portion of your income (as shown here).
So with a $46,154 of taxable income, you’ll calculate your income tax like this:
INCOME TAX DUE in SCENARIO 1
10% x 9,875 + 12% x (40,125 -9,876) + 22% x (46,154-40,125)
= 988 + 3,630 + 1,326
What would have happened in Scenario 2?
Now, let’s recalculate everything with the numbers from Scenario 2 where you only accounted for $12,000 in business expenses. Remember that in this scenario, you ended the year with a Net Earning of $73,000 and a total of $10,315 in Self Employment taxes.
Adjusted Gross Income in SCENARIO 2
$73,000 – ($3,000 + $2,000 + $1500 + $5,158*) = $61,342
* 50% of $10,315
Taxable Income in SCENARIO 2
$60,915 – $12,400 = $48,942
Income Tax in SCENARIO 2
[10% x $9,875] + [12% x ($40,125 – $9,876)] + [22% x ($48,942 – $40,125)]
= $988 + $3,630 + $1,940
That’s $614 MORE than in Scenario 1
By missing only $3,000 of eligible expenses, you ended up paying a total of $1,038 ($424 + $614) more in taxes. That’s why keeping track of your business expenses is so important.
And that’s how Lili’s expense management tool can help you save money on your taxes, by making sure you don’t miss or forget ANY deductions you’re eligible for. You’re welcome!
This blog is for educational purposes only and some elements were simplified for the sake of the example. You should always refer to the IRS website and official forms to determine what you actually owe.
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