The Finances of Freelancing: Tax Tips for Confused Contractors

Michele Lerner, The Motley Fool writes: Freelancers may love their freedom, but they don't always love the financial uncertainty that goes with being an independent contractor.

According to a recent survey by CreditDonkey.com, while 92 percent of those surveyed are happy to be freelancers, 56 percent said their biggest complaint is the uncertainty about their income.While handling a fluctuating income stream can be a challenge, many freelancers and contractors find the complications of paying taxes even more difficult. In fact, 16 percent of the freelancers surveyed by CreditDonkey.com said that at least once during their career, they haven't had the money to pay their taxes.

Watch Out for the IRS

Unlike traditional employees, who have their income taxes deducted from each paycheck, most freelancers and contractors don't have taxes deducted from their paychecks. Instead, they receive a 1099-MISC form from each client that pays them more than $600. The IRS gets copies too, and freelancers need paid estimated taxes quarterly to their state government as well as the federal government if they expect to owe more than $1,000. By the way, even if a client doesn't send you a 1099, you are required by law to report that income.

If you are a freelancer, the IRS Form 1040-ES includes a worksheet to help you estimate your taxes for each quarter based on your income, as well as on deductions and credits for the previous year. You may want to create a dedicated savings account solely for your tax payments.

Even if you have a full-time job but take on an occasional freelance project, you must report net earnings from self-employment of $400 or more on a Schedule SE (Form 1040).

Tax Forms

Most freelancers complete the Schedule C form, which sole proprietors use to report their profit and loss each year. If you are self-employed, have less than $5,000 in business expenses, no net losses, and no employees, you can use the Schedule C-EZ Net Profit From Business form.

Keep track of your business expenses all year and keep your receipts in case you are audited. In the area of deductions, pay close attention to these categories:

• Home office: Many freelancers work out of a home office but are afraid to claim the home office deduction because it's considered a red flag that increases your chances of an audit. However, if you legitimately work at home and are following the IRS guidelines found in Publication 587: Business Use of Your Home, you may want to consider taking the deduction. The main qualification is that the space you call your home office must be used exclusively for work.

Currently, the home office deduction allows you to deduct a percentage of your mortgage interest, homeowner's insurance, utility bills, home repair bills and depreciation. The percentage is based on how much of your home is used as an office, so if your "office" is a couch and a laptop, then you're not likely to qualify or even receive much of a financial benefit from the deduction.

In 2014, when you file your 2013 taxes, taking that home office deduction will get easier. Instead of filling out a long form to take the deduction, you'll be able to use a new optional deduction capped at $1,500. The qualification still holds that your home office must be used "regularly and exclusively for work," but the new form simplifies the process and lets you deduct $5 per square foot for your office on space up to 300 square feet. If your office is bigger than that or you regularly deduct more than $1,500 for it, you can still use the longer form.

• Computer: If you use it for personal business as well as work, you'll have to determine how much time you use it for each function. In other words, if you work on it 20 percent of the time and play with it 80 percent of the time, you can only deduct 20 percent of the cost on your taxes.

• Travel: If you travel for business, you can deduct 100 percent of your airfare and hotel stay and 100 percent of a meal eaten while working with colleagues. You can deduct 50 percent of your costs when entertaining clients.

• Health Care Expenses: As a freelancer, you can deduct your health care insurance premiums, including COBRA costs from your previous job.

IRS Publication 535: Self-Employed Health Insurance Deduction provides the details, but in general you must be reporting a new profit for your business on Schedule C or Schedule C-EZ.

• Retirement Savings: While you don't have the benefit of a 401(k) from an employer, you can open a Simplified Employee Pension (SEP) plan to build retirement savings and protect up to one-quarter of your earnings -- or a maximum of $50,000 -- from taxes. That's much higher than the cap on a traditional IRA.


More Than Anything, Be Prepared

Confused by all these IRS rules? You may want to consider the benefits of hiring a tax preparation expert or an accountant to make sure you are meeting all IRS requirements for freelancers.

The most important thing you need to do as an independent contractor is to sock away cash. Not only do you need to pay lump-sum quarterly taxes, but you need to have a bigger emergency fund than someone who receives a paycheck every two weeks.

Financial experts recommend that most people have three to six months of expenses saved in an emergency fund, but as a freelancer you should probably have six to nine or even 12 months of expenses saved. This is especially important if you are the sole financial provider for yourself or your family. Even the most successful freelancers experience some fluctuations in their income.

On the other hand, freelancers are not as reliant on a single employer. Most have several clients and successful freelancers are consistently marketing their services to bring in new business. So losing one client doesn't necessarily mean you'll need to dip into your emergency fund.