Freelancers: Beware of Write-Off Mentality

Share
More
Freelancers: Beware of Write-Off Mentality

When hanging out with fellow freelancers, I’ll often hear the phrase, "No biggie. I can totally write off [insert sleek new office gadget, e-course, or conference here] for taxes."

That’s when I cringe.

Freelancers frequently justify spending money on things they might not need for their businesses with the simple yet flawed reasoning that doing so will lower their taxes.

Here’s where this line of thinking is costly and why solopreneurs should avoid the "hey, I can just write this off for taxes" mentality.

You’re only reducing your tax base …

When you spend money and write it off as a business expense, you’re simply reducing your tax base, says Eric J. Nisall, founder of AccountLancer, which provides accounting services for freelancers.

So, he says, let’s say your taxable income is anywhere from $9,326 to $37,950, putting you in the 15% tax bracket.

If you spend $100 on, say, an annual membership to the Professional Society of Organic Banana Growers, you’ll save roughly $30 (15% on federal taxes and 15.3% on self-employment taxes).

But, Nisall says, you’ll be out $70 in cash.

In other words …

… you’re still spending money.

Not to knock the (albeit fictional) Professional Society of Organic Banana Growers or anything, but think about what that $100 could do for your rainy day fund, retirement accounts or other business expenses.

Sure, a lower tax bill is alluring, but you’ll want to consider the return on investment when spending money on X — and whether there’s a less-expensive alternative.

"The best thing to do is to make decisions based on the needs of your business, not just because someone else is doing it and not solely on the grounds of reducing taxes," says Nisall.

I get it. There have been many times I’ve been tempted to shell out dough on an e-course or conference when I don’t have the time to make the most out of it. The bottom line: If you don’t need it, it’s a waste of money.

Not all expenses can be deducted.

While most freelancers know the general business deduction categories, you’ll want to do know exactly what you can and can’t deduct come tax time. For instance, when it comes to health expenses, you can deduct your health insurance premiums. You can’t deduct out-of-pocket medical expenses, vitamins or that fancy piece of gym equipment. (By the way, you can find a freelancer 101 on health insurance right here.)

Plus, there are pretty strict requirements for writing off mixed-used assets — items used for personal and business expenses (i.e., your home or car).

Also, you can’t claim a business deduction for your home office if you actually work out of your dining room. It has to be a space in your home that’s used exclusively for your business.

There are other ways to reduce your taxable income.

Last year I found my taxable income was far lower than I expected, because I had squirreled money away in accounts that provided tax savings. Here are a few ways you can reduce your tax liabilities.

1. Contribute to a retirement plan.

"If you're looking to lower your income when you're self-employed, think of alternative deductions like contributing to a SEP IRA or Solo 401(k) to save for retirement," Shannah Compton Game, Certified Financial Planner and host of Millennial Money Podcast, says.

A SEP IRA, or Simplified Employee Pension Individual Retirement Arrangement, is a traditional IRA for self-employed workers and small business owners. It’s subject to the same rules as an IRA, meaning if you’ve set up your business as a sole proprietorship or partnership, you can deduct contributions on your individual taxes.

When it comes to a Solo 401(k), the plan is tax-deferred, meaning you won’t have to pay taxes until you start taking money out. You can make contributions to a Solo 401(k) as both an employee and as an employer.

Finally, contributing to an individual retirement plan that’s tax-deferred, such as a traditional IRA, can also save you money on taxes. The IRS has a handy guide to retirement accounts for self-employed individuals on its website.

2. Contribute to an HSA.

Contributions you make to a Health Savings Account (HSA) are also tax-deductible. And if they’re made through a payroll deduction, they come pre-taxed, which means you’re contributing money before taxes are deducted. The contribution limits in 2017 are $3,400 for individuals and $6,750 for families. I set up an HSA last year, and I’m currently trying to contribute to the plan as much as possible.

It may bite you on big-ticket purchases.

Here’s another important thing to keep in mind: If you want to rent or buy a big-ticket item, like a home or car, you need to show you can afford it.

"Taking out a mortgage requires you provide at least two years’ worth of tax returns to prove your income," Compton Game says. "If you've taken a big tax deduction for expenses, you could find it difficult to be approved for the loan."

As Nisall explains, "You can't have your cake and eat it too by showing high income to show you can afford, say, that car, and low income for tax purposes."

Want some more money management tips? You can find some financial mistakes every freelancer should avoid right here.