Being your own boss as a self-employed person has its upsides. But it's also challenging. For one thing, your taxes might be higher. Consider, for example, that people who earn a salary typically have 7.65% of their earnings taken out for Social Security and Medicare, with their employers contributing another 7.65%. Self-employed people, though, pay the whole 15.3% themselves. Still, there are ways that self-employed people can lower their taxes. Here are three examples.
Many self-employed people run their business -- or at least conduct a substantial part of it -- out of their homes. If that's the case for you, there are a lot of tax benefits you should be taking advantage of that are related to things that you may normally only think of as household expenses. For example, you may be able to deduct a portion of your mortgage, rent, utilities, and other expenses, such as housekeeping, as well as some or all of various home repairs or maintenance expenses.
How does it work? The most common way is by deducting expenses based on the percentage of the home dedicated to the business. For example, if you have one room that's dedicated solely to running your business, and that room is 15% of the total square footage of your home, then you could claim 15% of shared expenses as a business expense. This would be the same for repairs to the entire home, for instance, such as a new roof. A $5,000 new roof? A $750 deduction.
If you make repairs to that dedicated space -- for example, if you pay for electrical repairs only to the room you run the business out of -- you'd be able to deduct 100% of that as a business expense.
If you use a portion of your home to operate your business, take advantage of your ability to deduct a portion of the shared expenses in order to cut your tax bill.
One excellent deduction for self-employed individuals is the business use of a car. If you use your vehicle to meet with clients, drive to your office, or even drive to the bank to make a deposit into your business checking account, the expenses of operating your car are deductible.
You have two options when it comes to calculating the deduction. First, you can calculate your actual expenses such as fuel, maintenance costs, oil changes, new tires, registration fees, depreciation, and more. Or you can choose to take the IRS's standard deduction, which is $0.54 per mile for 2016.
In general, the standard deduction works out better for most people, as it can cost significantly less than $0.54 per mile to operate a modern, fuel-efficient vehicle. Of course, if you drive a truck or older vehicle with substantial maintenance expenses, it may be a good idea to keep track of your actual out-of-pocket expenses to see which produces the more lucrative deduction.
Whichever method you choose, you can only deduct the business usage of the vehicle, so it's smart to keep a mileage log to determine your business usage.
Another effective way for self-employed folks to lower their tax bills is to make use of retirement accounts such as the traditional IRA and the SEP IRA. Most people are familiar with traditional and Roth IRAs, which are available to most working Americans. Roth IRAs are funded with post-tax money, so they won't lower your upcoming tax bill. (They do offer the prospect of tax-free withdrawals in retirement, though, so give them serious consideration.) But traditional IRAs and SEP IRAs receive pre-tax contributions, meaning that if you contribute $5,000, you get to subtract that from your taxable income and thereby pay lower taxes. (You'll ultimately be taxed on that money when you make withdrawals in retirement.) The contribution limit for traditional and Roth IRAs is $5,500 for most people in 2016, with an additional $1,000 allowed for those 50 or older.
The SEP IRA (which gets its name from Simplified Employee Pension) is even more powerful, though, and available to self-employed people. Its contribution limit for 2016 is the lesser of 25% of your compensation or $53,000. That's right -- if you earn $200,000 in 2016, you can sock away a whopping $50,000! (If you earn a more common income, such as perhaps $80,000, you can contribute a solid $20,000. If you're in the 25% tax bracket and you reduce your taxable income by that $20,000, you'll be shaving $5,000 off your tax bill. See? It's powerful.)
It's also powerful in its ability to accumulate hefty retirement savings for you. If you can contribute $15,000 annually to a SEP IRA, and your account averages an annual 10% gain over 15 years, you'll end up with more than half a million dollars. Take a closer look at the SEP IRA to see if it makes sense for you.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.