There’s nothing quite like side hustling to make some extra cash to supplement your income and move closer to achieving your financial goals. Whether you’re working to repay debt, build an emergency fund, invest for your future, or just earn a little spending money – even a little bit of extra income can provide significant financial flexibility.
While it can be exciting to watch those side hustle dollars start piling up, don’t forget about the tax implications that come from earning money from a side hustle. There are some unique aspects to side hustle tax obligations. And of course, you’ll always want to consider ways to reduce your tax liability so you can keep more money in your pocket!
With the end of the year quickly approaching, I thought this would be a good time to take a closer look at the tax consequences that can impact your side hustle earnings. Whether your completing gigs with Takl, picking up passengers for Lyft, booking guests with AirBNB, walking dogs for Rover, or side hustling in some other way, you’ll want to pay attention.
If you’re like most people, taxes are an afterthought. And that’s especially the case for those who have traditional employment. That’s because your employer handles most of the tax-related work for you by deducting taxes before issuing each paycheck. After that, there really isn’t much left to do aside from filing your taxes and taking your refund check to the bank.
Side hustle income, however, is a little bit different.
If you’re side hustling, chances are that extra income is being earned in the form of 1099 income. Unlike W-2 employees who can count on their employer to take taxes straight out of their paycheck, 1099 wages are untouched income that flows straight into your pocket.
That means you’re responsible for paying applicable taxes yourself. So, if you treat your 1099 income the same way you treat your W-2 income, you’re probably in for a nasty surprise when tax season rolls around.
Side Hustle Taxes Explained
W-2 income is income that you earn from normal employment. In general, your employer will deduct the following taxes from those wages:
- Federal Income Tax
- State Income Tax
- FICA Taxes (employee portion)
If you have a side hustle, you are probably self-employed or functioning as an independent contractor. That means you likely receive one or more Form 1099s. A Form 1099 is a tax form that is used for miscellaneous income paid to non-employees (e.g., independent contractors). Here are the different taxes you’ll pay on your typical side hustle income:
- Federal Income Tax
- State Income Tax
- FICA Taxes (employer portion)
- FICA Taxes (employee portion)
You’ll notice that there’s one important difference between W-2 and 1099 taxes: the employer portion of your FICA taxes.
FICA is the tax that funds Social Security and Medicare programs. If you earn wages from normal employment, you pay your portion of FICA taxes (7.65%) through employer withholding. Your employer makes additional contributions on your behalf covering another 7.65%.
But if you are self-employed, you must to pay all 15.3% of FICA taxes yourself.
Think of it this way: as an independent contractor or someone who’s self-employed, you are both the employer and the employee. Since you’re assuming both roles, you’re responsible for paying both portions of FICA.
How Much Are You Paying?
Now that we’ve covered some income tax basics, let’s look at an example of the tax obligations that apply to side hustle income.
Here are the 2018 federal tax brackets:
Source: Tax Foundation
Let’s say you’re a single adult with a day job that pays you $50,000 a year.
And we’ll keep things simple by assuming that you’ll be taking a standard deduction. That places you in the 22% tax bracket.
That means that you’ll be paying at least $22 in federal income taxes on every $100 you earn on the side. You’re also responsible for both portions of FICA; so fork over another $15.30. And unless you live in a state with no income tax, you better prepare to hand over another chunk of your earnings to local government.
If you live in Arizona, here’s how taxes could affect your $100 in side hustle earnings:
- Federal Income Tax: $22.00 (22% tax rate)
- State Income Tax: $4.24 (4.24% tax rate)
- FICA Tax: $7.65 (7.65% employer portion)
- FICA Tax: $7.65 (7.65% employee portion)
Altogether, an Arizona resident making $50,000 annually will see that extra $100 in side hustle income reduced by $41.54 in taxes.
After starting with $100, you’re left with just $58.46!
There’s no way around it: that’s a major tax hit. Probably so much so, that you might be having second thoughts about whether it’s even worth it to put in those extra hours only to see the government take nearly half of your side hustle earnings.
Fortunately, if you’re side hustling as an independent contractor there are a few ways to reduce your tax liability so you can keep those hard-earned dollars in your pocket instead of handing them over to Uncle Sam.
Tips for Reducing Side Hustle Income Tax Liability
Those self-employment tax obligations might seem daunting, but here are a few ways you can reduce the amount you owe:
1. Use A Solo 401(k)
One of the best things about having a side hustle is that you can take advantage of extra retirement accounts that folks with normal employment can’t. If you start up a side hustle, you may be eligible to start stashing your side hustle income in a Solo 401(k), SEP-IRA, or a Simple IRA.
Let’s take a Solo 401(k) for example. A Solo 401(k) is the perfect retirement account for side hustlers. It’s just like a traditional 401(k), but better!
Like a regular 401(k), you can contribute up to $18,500 in 2018. In addition, you can also contribute 20% of your side hustle’s profits, up to $36,000! This is basically the equivalent of a traditional employer’s matching contributions to your regular 401(k).
Unfortunately, your employee contribution for all 401(k)s is limited to $18,500. So, if you’ll max out your employer 401(k), you’ll only be able to contribute the profit portion to your Solo 401(k). Still, that’s a pretty sweet double dip: contribute more money to a tax-advantaged retirement account and reduce your current tax liability!
2. Deduct Expenses to Reduce Net Profits
Business tax deductions can be a beautiful thing. The government lets you deduct expenses related to your side hustle for things you might already be doing anyway. And there are few things better than making or saving money by doing what you’re already doing!
You may not realize it but you may be able to deduct a wide range of expenses such as maintaining a home office, your supplies, internet, utilities, insurance, auto expenses, and travel costs.
Why is this such a big deal? Keep in mind, when you pay for goods, you’re normally using post-tax income. That means the burrito I just purchased wasn’t really $5. To pay for that burrito, I probably had to earn close to $7 in pre-tax money which equals roughly $5 in post-tax income.
Side hustle earnings, on the other hand, allow you to pay for expenses related to your side hustle with completely untaxed money. So, the $5 I spent on that burrito (assuming it was somehow a business-related expense) wouldn’t ever be whittled away at by taxes.
The point is, with a little planning you can enjoy major savings on your taxes. Of course, you’ll want to make sure you keep thorough and accurate records and follow IRS guidelines. Better yet, seek advice from an accountant or financial advisor. In fact, the cost to hire a tax expert might even be deductible too!
3. Report Side Hustle Income on Schedule E
In general, most of your side hustle income will end up on Schedule C. Schedule C is a tax form for small business owners and sole proprietors that shows the income of a business for the tax year, as well as deductible expenses. The downside to filing Schedule C is that you have to pay both the employer and employee portion of FICA (i.e., an extra 15.3% in taxes).
The good news is that there are certain types of side hustle income that need not be reported on Schedule C. Instead, you may be able to file Schedule E.
Schedule E is used to report income (or loss) from rental real estate, royalties, estates, and partnerships. The benefit of filing Schedule E is that you don’t have to pay FICA taxes on it. That means you can reduce your side hustle tax liabilities by another 15.3%.
A Few Final Thoughts
There are so many ways to build up extra cash outside of your day job. But don’t let the informal nature of the gig economy fool you into thinking that paying taxes on that extra income is optional.
There’s a lot to keep track of, but don’t let it overwhelm you. Get organized and start planning now so you can make the most of that side hustle income, and maybe even take advantage of that Solo 401(k). You won’t regret it!