A friend asked me about taxes and freelancing recently. This crops up often enough that I thought I’d share my answers with the rest of the world—well, really the US, as that’s where I pay my taxes. I’ve run freelancing business seminars that have covered this in the past, so this is going to be the encapsulated version.
Note that I’m not an attorney or an accountant, just someone who’s had to deal with this a lot over the years. This is complicated stuff and can vary from state to state, so for expert advice, I recommend contacting one of each in your area.
Any money you make from freelancing is subject to self-employment tax (assuming you’re not incorporated, but more about that in a minute). The self-employment tax in the US is 15.3%. According to Wikipedia: “Half of the hypothetical self-employment tax is allowed as a deduction against self-employment income so only 92.35% of the self-employment income is taxable at 15.30%, an effective tax rate of about 14.13%.”
For regular employees (W-2 folks), the employer covers half of the employee’s payroll taxes (Social Security, Medicare, and FICA). That’s half the self-employment tax rate, or 7.65%. W-2 employees split the taxes with the employer, but the self-employed have to pay both halves of that. This means that you effectively take a 7.65% penalty to be self-employed.
On top of that, like everyone else, you have your standard income tax bracket, which depends on how much you make during the year and how you file. Most folks fall into the 15% bracket, or really $1,565.00 plus 15% of the amount over 15,650. (That’s 10% on the first chunk and 15% after that.)
When planning your budget, though, you need to make sure you put away that tax money aside, because you won’t have the enforced discipline of your employer withholding the taxes from your paycheck like they do for W-2 employees. Instead, you’ll end up having to pay quarterly estimates (look for the 1040-ES forms) to make sure you don’t get nailed with a penalty at the end of the year.
If you wind up making more than, say, $35k in a year, it might be worth it to incorporate as an LLC or S-corp. You then hire yourself and pay yourself a small but reasonable salary. That way you only pay the payroll taxes (that total 15.3%) on the salary you earn, while the rest only gets taxed at the standard income tax rates.
I run my business as an S-corp and have saved thousands of dollars every year that way. This does limit your social security funding, which may come back to hurt you later, but that’s only true if social security doesn’t change a great deal between now and when you’re old enough to collect it.
Incorporation comes with a pile of paperwork you have to deal with on a monthly basis, but it also provides you with a layer of personal protection should someone somehow wind up trying to sue you over your work. Also, for a number of good reasons, some large businesses prefer to hire corporations for contract positions rather than individuals. Others insist on it.
One of the secrets to success at freelancing is recognizing it for what it is: a business. If you want to do well at it, treat it that way and get professional advice to help you make the most out of it. Good luck!