More and more Americans are trying their hand at generating income through a side gig–as much as 54% of the workforce, according to one survey. While that’s certainly an impressive statistic, it should not be surprising. The costs of living and homeownership have experienced a sharp increase, driving the desire to find opportunities for supplemental income. For many, it’s also a good way to generate a little spending money, especially when it’s a low- or no-commitment side gig like Uber, Lyft, or an Etsy shop.
If you’re considering starting or expanding a side hustle, it’s essential to keep two things in mind. First, income on the side doesn’t mean income under the table, and you don’t want to end up on the wrong side of the IRS. Second, if you think your side hustle has the potential to become your full-time job or at least serve as a significant portion of your income, you need to think about how it fits into your long-term financial goals. With those two things in mind, here’s what you need to ask about self-employment tax rates and retirement planning for self-employed individuals.
How Are Side Hustles Taxed?
Traditional Vs Self-Employed Taxes
If you’ve been a traditional employee, you’re likely accustomed to your employer withholding your estimated income tax from your checks and receiving a W-2 at the end of the year with the totals they’ve paid on your behalf. You might even receive a refund for overpayment from the IRS when you complete your taxes.
Income from side hustles like Lyft or Uber is usually considered self-employed independent contractor work. Unlike your W-2 work, you will be responsible for tracking and reporting your income and taxes. The IRS follows a “pay-as-you-go” system, meaning taxes are expected to be paid throughout the year as you earn income—not just at tax time. If you’ve received over $600 from one person or company, they are responsible for sending you and the IRS the total amount they’ve paid you in a 1099-NEC form at the beginning of the following year. The IRS will use this form to verify that you’ve reported your self-employment income correctly.
One of the biggest surprises many self-employed persons find is how much they must pay in taxes at the end of the year. While taxes from a traditional W-2 job are automatically deducted from your paycheck each month, for 1099 contractors, it can be a rude awakening to be the ones physically paying them, especially if you forget about them until tax season. On top of that, the Federal tax obligation for W-2 income is split evenly between you and your employer. Under current law, you and your employer typically pay 6.2% of your earnings toward Social Security and 1.45% toward Medicare. For income you earn as a self-employed individual, you must pay both the employer and employee portions of FICA taxes, which totals 15.3% (12.4% for Social Security and 2.9% for Medicare), and you may also owe penalties if you underpay or miss your estimated quarterly tax payments (via IRS).
Maximizing Write-Offs
So, does that mean you may be taxed more on the income you earn from a side hustle? Yes, but that doesn’t necessarily mean you’ll owe twice as much in taxes. Business owners may be able to write off the expenses associated with running the business, which can lower their overall taxable income. As a self-employed individual, you may get to do the same. If you drive for Uber or Lyft, you might have the option to write off expenses like gas and mileage on your car, in correlation to how many miles you drive. If you work from home, you might be able to write off a portion of your utilities and rent or mortgage, as well as any materials you purchase for work or the annual depreciation of things you already own and use. Get good help–working with a professional tax preparer can help you consider every applicable deduction and might significantly lower your taxable income.
Paying Self-Employment Taxes Throughout The Year
Another difference between traditional employment and self-employment is when you pay your taxes. We briefly mentioned above that if you’re earning income throughout the year, whether through a W-2 job or self-employment, you’re expected to pay taxes as you earn it—not just when you file your return in April. For W-2 employees, your employer does this for you by withholding taxes from each paycheck. For self-employed individuals you may be responsible for making those payments regularly.
The IRS offers a quarterly estimated tax payment system to help you meet this pay-as-you-go rule. If you don’t make those payments throughout the year and you owe more than $1,000 in taxes when you file, the IRS may charge an underpayment penalty—not because you skipped quarterly payments per se, but because you didn’t pay in time as you earned. You can use Form 1040-ES to make quarterly payments, and we recommend consulting a tax professional. While paying quarterly may feel like a bitter pill to swallow, it can help you get into the practice of setting aside regular, monthly amounts for estimated bills rather than forgetting about them until the whole lump sum is due.
How Can I Use My Side Hustle for Retirement?
If you want to use supplemental income for more than just fun money, it’s a good idea to consider which retirement savings vehicle fits your situation. Retirement planning for self-employed individuals comes with unique challenges but isn’t without opportunities. The two most common ways for self-employed individuals to save for retirement are with a Roth IRA or a SEP IRA. Check out how they compare: https://smartasset.com/retirement/sep-ira-vs-roth-ira-whats-the-difference
As you will see, each option has advantages and disadvantages, and finding the right fit depends on your situation. If you have a 401(k) through an employer for your main job, that can also significantly impact your taxes in retirement. You don’t have to choose–you may be able to contribute to a Roth IRA in addition to a SEP IRA, even on top of a 401(k). It all depends on your overall financial strategy and what makes sense for your situation, so it’s a good idea to loop in your financial advisor and tax professional.
Harnessing Your Side Hustle Income
Income on the side can be a good way to fund the fun stuff, like vacations, hobbies, holiday expenses, or even a personal allowance. However, if your main job doesn’t generate enough income to cover your financial bases, it’s wise to manage side hustle income with the same discipline as your regular paycheck. Make sure Bucket #1, your emergency fund, is full. If a significant portion of your income comes from a side gig, consider sizing up your emergency fund since that income is often less predictable. Once that’s taken care of, set aside money in Bucket #2 for those anticipated, irregular expenses–this is where you can save up for quarterly estimated taxes. After that, focus on maximizing your retirement contributions so you can Retire To Your Happy Place™.
Starting or growing a side hustle can be an exciting experience. Just make sure you get expert advice to understand the tax implications and use the income in a way that makes your life easier and brings your goals closer. We want you to be Smart About Money™ so you can uncomplicate your finances and enjoy life on your terms!
Material provided, in part, by Kalli Collective, an independent third-party, Raymond James is not affiliated with Kalli Collective.
Any opinions are those of Traci Richmond and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of the strategy selected, including asset allocation and diversification. Past performance is not indicative of future results.
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