Year-End Tax-Planning and Deferred Income Tips for the Self-Employed

Freelancers and other self-employed taxpayers have several strategies available to them to help mitigate the cost of some taxes and to optimize their tax situations. You can accelerate or defer income, as well as accelerate or defer deductions, but that means making some important decisions as the year draws to a close.

The Cash Method of Accounting

Before we get into strategies for year-end tax planning, let's understand the mechanics of income accounting and how it can impact the taxes you owe.

The timing of income and deductions depends on a self-employed taxpayer's accounting method. The majority of self-employed workers and many small businesses use the cash method of accounting. This means that you would include in your gross income money that you actually or constructively received during the tax year. "Constructively" means that income is credited or made available to you without restriction, such as a check you receive in December that you don't deposit until January.

You could have deposited it when you received it, but if that check were postdated for January, your control of the money would be subject to restriction. 

Deductions are somewhat different. You have no choice but to deduct them when you actually pay them, but you do have some flexibility as to when you pay them.

How Acceleration and Deferral Work

Accelerating income and deferring deductions increase the amount of income that's taxed in the current year.

These can be useful strategies if your income falls into a lower tax bracket this year but you expect you'll be in a higher bracket net year. In that case, you want as much income as possible to be taxed at this year's lower rates.

• Accelerating income means trying to bring in more money in the current year. Target income that's on the cusp so you might feasibly receive it by year's end.
• Accelerating deductions means spending money on expenses that will generate a tax deduction now rather than next year. 
• Deferring income means postponing or delaying the receipt of certain revenues until a future year. Again, target income that's on the cusp so it might reasonably be postponed until next year.
• Deferring deductions means holding off on spending money on tax-deductible expenses until next year, or even later years when those deductions might be more advantageous to your tax situation.

These four tactics revolve around the proper timing of paid income and the use of deductions for tax-related purposes.

Income Acceleration Strategies, Benefits, and Risks

Accelerating income to this year could result in that income being taxed at a lower rate if you're in the 22% tax bracket this year, and you expect that you'll be in the 24% bracket next year. Strategies for accelerating income include:

• Ask clients or customers to pay now.
• Call or write those who are behind in paying your invoices, and collect sooner rather than later.
• Ask for larger up-front payments for projects that will span this year and next.

Not only do these practices accelerate income, but they will also clean up your accounts receivable. There's a caveat, though. Tax brackets are based on the amount of your income, so taking in too much income this year could possibly push you up into that 24% bracket. You probably want to increase your income as much as possible without pushing yourself into a higher tax bracket.

Income Deferral Strategies and Benefits

You might want to push your income into a lower tax bracket by deferring income to the following year if you're in the 24% bracket this year but expect to be in the 22% bracket next year.

This can be another good reason to nudge some business income forward. When you reach the top of your uppermost tax bracket, why go over and pay a higher rate if you can defer that income to the next year and possibly be taxed at the same rate?

Strategies for deferring income include:

• Avoid trying to collect delinquent accounts until the calendar flips over.
• Ask for smaller up-front payments for projects that span this year and next.
• Send out December invoices after January 1.

Deduction Acceleration and Deferral Strategies

To accelerate your deductions, buy equipment and supplies this year instead of next year.

Computers, software, vehicles, furniture, and other types of equipment are depreciated over multiple years—which in itself is a form of deduction deferral—or they can be written off immediately using the Section 179 deduction. Section 179 allows businesses to claim up to $1.05 million in deductions for qualifying new or used equipment. You must place the equipment in service in the current year if you use the Section 179 strategy.

Other deduction-acceleration strategies include:

• Stocking up on office supplies
• Paying bonuses to your employees this year rather than after the first of the year
• Paying fourth quarter payroll taxes in December rather than in January

To defer deductions until next year, you'll want to use the opposite strategies:

• Putting off investments in computers and other equipment until next year
• Waiting to stock up on supplies and other office necessities if possible
• Pay bonuses to your employees in January instead of December

Self-Employment Taxes

You'll also want to keep an eye on the self-employment tax, which consists of two components: Social Security and Medicare. Typically, employers pay half of these taxes on behalf of their workers, but you must pay both halves yourself if you're self-employed.

You need to pay self-employment taxes and file Schedule SE with your tax return if your net earnings from self-employment exceed $400 or your church employee income is $108.28 or more.

The Social Security Tax

The 12.4% Social Security tax stops when a taxpayer's income exceeds $147,000 in 2022, or 160,200 in 2023. Annual income over this amount isn't subject to that tax, but your earnings start again at zero on January 1, and the tax kicks back in.

Consider accelerating income if you're close to this threshold, because anything you earn over this amount would not be subject to this tax.

The Additional Medicare Tax

The Additional Medicare Tax is 0.9% on top of the 2.9% Medicare tax that's included as part of the self-employment tax.

It applies when your income reaches:

• $200,000 for single filers or head-of-household filers
• $250,000 for married couples filing jointly
• $125,000 for married couples filing separately

This additional tax is assessed on the combined Medicare wages and net self-employment income for both spouses if you file jointly with your spouse. Avoid accelerating too much income if you're considering an income-acceleration strategy, potentially pushing yourself over the threshold to the point where this Additional Medicare Tax would come due.

Self-employed taxpayers whose incomes are near the thresholds for the Additional Medicare Tax might want to consider deferring income if it would keep them below the threshold for both this year and the next. 

Review Your Retirement Plan

Self-employed people have several options when it comes to retirement plans, including SEP-IRAs, SIMPLE IRAs, and 401(k) plans.

SIMPLE plans must be established before October 1, and 401(k) plans must be established by December 31.

Contributions to an IRA can be made up until April 15 of the following year. SEP-IRA contributions can be made until April 15 or until the date of any extension you have sought to file your tax return.

Keep an eye on these dates so you can make tax-deductible contributions at the most opportune time.

Your Choice of Business Entity Matters

Freelancers often work for themselves without any formal business structure. That might be a fine fit for your needs, but there are other possibilities. Consider forming:

• A corporation
• A partnership
• A limited liability company (LLC)
• Another formal structure

For example, Section 199A deduction, the Qualified Business Income (QBI) deduction that allows certain businesses to shave 20% off their annual incomes beginning in 2018 and going forward.

For the 2022 tax year, the threshold amount for this deduction is $340,100 for married-filing-jointly returns, $170,050 for married filing separate returns, and for all other returns.

Many sole proprietorships and partnerships are eligible, as are S corporations and limited liability companies, but C corporations are not eligible—something to keep in mind if you would otherwise qualify for this deduction.

Estimated Tax Payments

You'll also want to set up a plan for tax payments that are due next year, because the IRS prefers to be paid as you earn. This includes the fourth estimated tax payment, which is due by January 15.

An extension payment, if any, is typically due by April 15, and the first estimated tax payment for the new year is also due on April 15. Quarterly estimated tax payments are normally due by:

• April 15, June 15, and September 15 in the current calendar year
• January 15 of the following year

These dates might be extended by a day or two in some years if the 15th of the month falls on a weekend or a national holiday. 

Get a preliminary idea of what your tax liabilities will be this year so you will have an idea of how much you should set aside for this year's and next year's taxes.

Frequently Asked Questions (FAQs)