The classic first-year freelancer story goes like this. You earned about the same as your old salary, you set aside what felt like a sensible amount, and the return says you owe far more than you saved. Nothing went wrong. You have simply met self-employment tax.
You are now both halves of the payroll tax
On a W-2, Social Security and Medicare cost you 7.65 percent of wages, and your employer quietly pays the same amount again. When you work for yourself, you are both parties, so the combined rate of 15.3 percent lands entirely on you. That is on top of income tax, not instead of it.
The calculation has three mechanical steps, set out by the IRS in its explanation of self-employment tax:
- Take net profit, which is income minus business expenses, and multiply by 92.35 percent. This adjustment exists because an employee's share is calculated on wages that already exclude the employer's half.
- Apply 12.4 percent for Social Security, but only up to the annual wage base. Above that, the Social Security portion stops.
- Apply 2.9 percent for Medicare on the whole amount, with no ceiling, plus an extra 0.9 percent above a fixed high-income threshold.
Half of the resulting tax is then deductible against your income tax. It does not reduce the self-employment tax itself.
Profit, not revenue
Every dollar of legitimate business expense reduces both income tax and self-employment tax, which makes deductions worth roughly a third more to a self-employed person than to an employee in the same bracket. The test is that an expense must be ordinary and necessary for your trade. Common categories:
- Supplies, materials and software subscriptions.
- Professional fees, licences and continuing education in your existing field.
- Advertising, website hosting and platform fees.
- Business insurance, including liability and professional indemnity.
- Business use of a vehicle, either at the standard mileage rate or by actual costs, backed by a contemporaneous log.
- Business travel, and the deductible share of business meals.
- Equipment, either depreciated over time or expensed in the year of purchase under the available elections.
The home office deduction is not an audit magnet
It has a persistent reputation for triggering audits, and it does not deserve it. The requirement is that a space is used regularly and exclusively for business, and that it is your principal place of business. Exclusively is the word that catches people: a desk in the corner of a bedroom qualifies if that corner is not also where the family computer lives.
There are two methods. The simplified method deducts a fixed amount per square foot up to 300 square feet, needs almost no records, and takes one line. The regular method allocates actual home costs by square footage and usually produces a larger number for anyone with a meaningful mortgage or rent. The IRS sets out both in its guidance on the home office deduction.
Retirement plans do the heavy lifting
A self-employed person has access to plans an employee usually does not. A SEP-IRA allows a contribution of up to 25 percent of net self-employment earnings, subject to an annual dollar cap, and can be opened and funded after year end. A solo 401(k) allows both an employee deferral and an employer contribution, which often produces a larger total at moderate income levels, but generally has to be established before the end of the tax year. Contributions reduce income tax, though not self-employment tax.
The IRS compares the options in its overview of retirement plans for self-employed people. This is the single largest lever most profitable freelancers have, and it is routinely ignored until the return is already being prepared.
The 20 percent business income deduction
Sole proprietors, partners and S corporation shareholders can generally deduct up to 20 percent of qualified business income, subject to income-based limits and additional restrictions for certain service businesses at higher incomes. It comes off taxable income rather than off the business, and it does not reduce self-employment tax. It is worth understanding because it changes the answer to "should I incorporate" more often than people expect.
Quarterly payments are not optional
The tax system is pay as you go. With no employer withholding, you make estimated payments four times a year, and missing them produces an underpayment penalty even if you pay in full by April. The safe harbours are worth memorising: pay 90 percent of the current year's tax, or 100 percent of last year's (110 percent if your income was above the higher threshold), and the penalty does not apply.
Read the detail in quarterly estimated taxes explained, and see the current rules on the IRS estimated taxes page.
Records that survive a question
Separate bank account, from day one. It is not a legal requirement for a sole proprietor and it is the single best thing you can do for both bookkeeping cost and audit defence. Add a mileage log kept as you drive, receipts for anything over a trivial amount, and a monthly habit of categorising transactions rather than a March marathon.
If that sounds like more than you want to do, that is precisely what a bookkeeping practice is for, and the fee is itself deductible.