6 second take: Adding a side hustle can be a great way to get ahead financially, but you’ll still need to pay taxes on your side business.

Many Americans are taking steps to improve control over their financial lives with the help of a side hustle. Extra income can do wonders to ease a tight or challenging financial situation, or it can help accelerate growth in an already solid financial situation. Increased income, however, comes with increased taxes.

Many people enter the gig economy without adequate knowledge of how their newfound income will be taxed or what their new responsibilities for managing these taxes will be. The U.S. tax system is a progressive system; you pay at a higher rate on additional income than you do on your first dollars earned during the year.

But making more money will always be advantageous; you cannot end up with less money by making more.

There are many horror stories out there about people netting less money because they got pushed into a higher tax bracket or some such thing; the truth is that you can’t end up with less by making more. Sensational stories are sensational, but often based on misunderstanding our tax system.

The bottom line is that it is always better, in our tax system, to make more money. The next step after figuring out how to make it is figuring out how to legally keep as much as possible. You have to know a little bit about how the system works. 

Employment vs. Self-Employment

When you are employed, your employer handles taking your tax withholdings and making the appropriate deposits. In addition to federal withholdings and their state counterparts where appropriate, employers withhold FICA taxes. FICA taxes include your employee contributions for Social Security and Medicare taxes.

In addition to the FICA taxes your employer withholds from your check, your employer makes an equal contribution on your behalf. When you are self-employed, however, you have to do both sides; instead of being responsible for half of the tax as an employee, you are responsible for the whole thing. And it may be significant. 

As an employee you pay a 6.2 percent Social Security tax on your first $142,800 of wages in 2021. Additionally, you pay Medicare tax of 1.45 percent on all your wages; there is no cap. The combined tax is 7.65 percent for earnings under the Social Security wage cap.

As a self-employed person, you pay 15.3 percent self-employment tax on your net earnings, double the 7.65 percent rate you pay as an employee. This is in addition to federal and possibly state tax on those earnings. 

One-half of your self-employment tax is deductible for federal tax purposes.

An important key is that taxes, both self-employment taxes and income taxes, are based upon your net earnings. You’re not taxed on every dollar you bring in from your side business — only on your profit. 

Profit or Loss from Business

As an independent contractor, which is generally what most non-employee side gigs will be, you are taxed on the profit you generate and may be able to benefit, taxwise, from some losses. You determine your taxable business income using schedule C.

Most self-employment income comes from you providing a good or service for which you have expenses to produce.

If you drive for a ride share program or deliver for a takeout or grocery service, you have expenses for your vehicle as a result of doing your side gig. If you sell pies, or something else you produce, you have the cost of making those goods. Generally, you also have other expenses related to your business endeavor, even the cost of having your side business taxes prepared.

The IRS allows you to deduct those expenses that are ordinary and necessary for your business. Though this provides a bit of leeway, it precludes you from getting overly creative in what you try to deduct. 

Two places where people tend to get tripped up are business use of automobiles and business use of the home. 

There are two methods you could use for deducting expenses for business use of an automobile. You can use either an IRS standard mileage rate or your pro-rata share of actual expenses. It may be worthwhile to estimate which would work best for you beforehand.

Oftentimes the actual expenses method may yield a higher deduction when you have a newer car where your depreciation expense is higher, and the standard mileage rate may be more advantageous when you have an older vehicle where there is little to depreciate.

If you start with the actual expense method, you cannot switch to the standard mileage rate later for the same vehicle, precluding you from capitalizing on the best of both worlds. 

If you use a portion of your home for side business use, you should be familiar with the rules for taking a business use tax deduction. Generally the space has to be necessary for you to conduct the business and not used for personal use. It needs to be for business use only.

Your deduction is the pro rata share of house expenses based on the percent of square footage used for business purposes. 

You deduct your business expenses from your business income to determine the profit that you are taxed on, both income tax and self-employment tax. It is in your interest to make certain you take advantage of all you legally can to reduce your net income. 

Recordkeeping

The key that helps both to minimize your taxes and make them as easy as possible is good recordkeeping.

Those who keep good records don’t waste time at the end of the year trying to figure out where all the money went; they have the records. And they generally don’t miss the smaller expenses, which can easily fall through the cracks if you fail to keep track on an ongoing basis. 

One thing that helps is separating your self-employment or business expenses from your personal expenses. Use a separate checking and don’t mix the two. It makes the recordkeeping much easier if everything connected to the business is run through one account, or a couple dedicated accounts if there is enough volume to warrant. 

Estimated Taxes

Our tax system is a pay-as-you-go system; the IRS expects you to pay your taxes throughout the year, or possibly face a penalty.

Quarterly estimated taxes are not difficult. You make estimated tax payments of one-quarter of your estimated taxes by April 15, June 15, September 15, and a final payment by January 15 of the next year.

You do not need to make the final estimated payment if you file your taxes by January 31. You may be subject to penalty if your total pre-payments don’t cover 90 percent of your liability.

If your side gig is small and you tend to get a refund from your regular employment, you may not need to make estimated payments or may be able to cover your liability through increased withholdings at work. 

If your side gig brings in a lot of income, you might want to consult a tax advisor for assistance with your estimated payments. 

The Bottom Line

Adding a side hustle can be a great way to get ahead financially. Some side hustles grow into full-time endeavors and free people from the nine-to-five grind and set them on the road to financial independence. 

Whether you are adding a side hustle to ease your current finances or for some other purpose, a key to successfully integrating a side business into your finances is to properly manage your taxes. Taxation of independent contractor earnings is not overly difficult but may be different from what you are used to if most of your work has been as an employee. By investing a little up front to set up good recordkeeping systems and find out what you can deduct, you can help yourself keep as much of your hard-earned income as possible.