If you are one of the lucky business owners whose business is flourishing, you may be wondering how to keep as much of your earnings as possible as tax season nears. While you definitely need to pay the tax due on your earnings from all sources, you shouldn’t set yourself up to pay more tax than is necessary.
This summary of tax brackets for 2022 will help you plan your actual tax obligations based on your income so you can take informed action to reduce the amount of tax you pay as much as possible. Keep in mind that in addition to federal income tax rates there are also self-employment taxes on earned income as well as state and local tax obligations depending on jurisdiction.
Here are some key tax strategies you can employ to reduce your tax obligations the right way if your income has increased significantly. It may be too late to leverage them on your 2022 taxes but keep them in mind as you plan for 2023.
A word of caution: these strategies may not apply in your specific situation, so be sure to check in with a tax professional who can help you determine the best course of action for you.
1. Investing in tax-free savings accounts (TFSA). Making contributions to tax-free savings accounts allows your money to grow tax-free, and there is no tax incurred on future withdrawals. A Roth IRA or a Health Savings Account (HSA) may qualify here.
A health savings account allows you to put pre-tax dollars aside to cover medical bills and expenses that are not covered by health insurance such as visits to dentists, eye doctors, and other specialists. If your income is sufficient, it may be worthwhile opting into a high-deductible health insurance plan and using a health savings account for co-pays and deductibles where the money is exempt from federal income taxes, state or local taxes, and FICA taxes. When you use the money, it’s still tax free.
2. Maximizing retirement savings account contributions. If you have an IRA, SEP IRA, Solo 401(k) or other qualified retirement accounts you will want to maximize your contributions to them to reduce your taxable income. The investment income and/or capital gains you generate through these accounts will not be taxed until you withdraw it in the future. You do not want to withdraw these dollars before you reach the RMD (required minimum distributions age) otherwise you will be subject to additional taxes.
There are some important changes to the thresholds for retirement accounts. In 2023, participants aged 50 and older can contribute an extra $7,500 per year annually into their 401(k) account. This amount will increase to $10,000 per year (indexed for inflation) starting in 2025 for participants aged 60 to 63. Also, after 2023, all catch-up contributions for participants earning over $145,000 annually must be made on a Roth (after-tax) basis.
3. Accelerating eligible deductions. Accelerating depreciation and other eligible deductions can be key to maximizing the benefits of multi-year tax planning. By deducting allowable expenses from your taxable income, you will be able to reduce taxes owed. When it comes to depreciation, be sure to check with a tax professional to ensure your calculations are accurate in regard to the impact of depreciation on your taxes.
4. Take advantage of the pass-through deduction. Another potential tax deduction for your freelance business is the 20% Qualified Business Income Deduction (QBI) on business income for pass-through entities. If your freelance business operates as one of these pass-through entity types you may be eligible:
- sole proprietorship.
An important distinction about the QBI, is that it is not based on the traditional definition of business income. Instead, it uses “qualified business income” to calculate any deduction to which you may be entitled. There’s also an income-based limitation on the amount of the deduction.
Some types of businesses, referred to as a Specified Service Trade or Business (SSTB) are not eligible for the deduction once certain income thresholds are met. From the IRS’s standpoint this is “a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business principal asset is the reputation or skill of one or more of its employees or owners.”
QBI is calculated from the income you derive from your pass-through business minus any net capital gains or short-term capital losses. (A pass-through business is one in which the business income is reported and taxed on the owner’s individual tax return.) In addition, QBI does not include pass-through income from W-2 wages received from an S-corporation or from the guaranteed payments received from a partnership.
The amount you can deduct is also subject to caps of either 50% of the wages your business pays its employees or 25% of wages plus 2.5% of the basis of the business’s qualified property — whichever is higher. These calculations must be compared to the 20% of your QBI; then you may deduct whichever amount is less.
However, there are thresholds after which the deduction phases out for the 2022 tax year, they are:
- $170,050 for a single filer
- $340,100 for a joint filer
Once you hit these limits, your QBI deduction will start to “phase out,” meaning you only get a partial deduction. There’s more scaling back of the QBI deduction if you make more than that limit, at the even higher income threshold of the following you will encounter the additional limitations below:
- $220,050 for a single filer
- $440,100 for a joint filer
The pass-through deduction is in effect through the tax year 2025. To make sure you do maximize these and other deductions you are eligible for, it is advisable to check with a tax professional.
Make the most of deductions on your return and make a plan for the current tax year. If 2022 was a great year for your business, you may have the tax bill to prove it! Use the strategies above to mitigate as much of the tax you owe as possible and also keep looking ahead if your current year profit and income is going to be strong as well. In addition, keep your records up to date so you can take advantage of these deductions without being the target of a red flag for an IRS audit.