Detail the specific types of deductions that are available to self-employed individuals, beyond the general deductions, and how these differ from those available to salaried employees.
Self-employed individuals, often freelancers, independent contractors, and small business owners, have access to a variety of unique deductions not available to salaried employees. These deductions often reflect the unique challenges and costs associated with running a business, which is fundamentally different from being employed by another company. While both employees and self-employed individuals can claim deductions such as IRA contributions or student loan interest, the scope of business-related deductions differs significantly.
One of the most notable distinctions is the ability for self-employed individuals to deduct business expenses directly from their business income. These are referred to as "above-the-line" deductions because they reduce the gross business income to arrive at the net profit, whereas many deductions for employees are "below-the-line" and are itemized on Schedule A. For a salaried employee, many of their expenses are considered personal and are not deductible. A self-employed person has more latitude to deduct business-related expenses to reduce their taxable profit.
Examples of specific deductions available to self-employed individuals include deductions for business expenses such as advertising, marketing, office supplies, and utilities. For instance, if a freelance graphic designer pays for advertising online, these expenses can be directly deducted from their business revenue. A salaried employee, however, would not be able to deduct the costs of marketing or advertising their skills, unless they were for a different business they own. The costs for travel expenses, if they are primarily for business, such as travel to meet with clients, can be deducted by a self-employed person, including meals (subject to 50% limit) and lodging expenses, if the trip is for business purposes. A salaried employee generally cannot deduct their travel expenses for their usual job.
Home office deductions also provide significant tax savings for self-employed individuals. As long as a portion of their home is used exclusively and regularly for their business, they can deduct the expenses associated with that part of their home. This includes a percentage of their mortgage interest, property taxes, homeowner’s insurance, utilities, and even repairs and maintenance. An employee cannot generally claim the home office deduction except under very specific and restrictive circumstances that rarely apply.
Self-employment tax is another area where self-employed individuals have a unique tax situation. Unlike employees, who have 50% of Social Security and Medicare tax covered by their employers, self-employed individuals pay both the employer and employee portion of these taxes. However, self-employed taxpayers can deduct one-half of their self-employment tax from their adjusted gross income. This helps to offset the tax burden for those who do not have the benefit of employer matching.
Another important deduction is the deduction for health insurance premiums. Self-employed individuals who pay for their own health insurance can deduct 100% of their health insurance premiums from their adjusted gross income, provided they are not eligible for employer-sponsored health insurance or that of their spouse. This deduction helps offset the often-substantial cost of health insurance for the self-employed, and is not generally available to salaried employees unless they itemize, and even then only the amount that exceeds 7.5% of their adjusted gross income is deductible.
Self-employed individuals can also contribute to a Simplified Employee Pension (SEP) IRA or a solo 401(k). These options offer significantly higher contribution limits compared to traditional IRAs, which allows them to save more for retirement and at the same time reduce their tax liability in the current year. Salaried employees may also have retirement plans, but their contribution limitations and plan features are usually not the same.
The qualified business income (QBI) deduction is another substantial deduction available to self-employed individuals. This deduction, implemented by the Tax Cuts and Jobs Act (TCJA) of 2017, allows eligible business owners to deduct up to 20% of their qualified business income. This can provide a significant reduction in their taxable income, but it can also be very complex, with specific income limitations and thresholds, and does not apply to salaried employees. This is a valuable deduction for self-employed and other small business owners.
In summary, self-employed individuals have unique access to many business-related deductions, such as business expenses, home office expenses, self-employment tax deductions, health insurance premium deductions, and QBI deductions that are not generally available to salaried employees. These unique rules are meant to level the playing field for self-employed persons since they carry a higher overall tax burden with their various business expenses. Understanding and accurately applying these deductions is essential for self-employed individuals to minimize their tax liability and maximize their after-tax income. Failing to track and accurately claim all deductions can leave money on the table.