NOBODY LIKES TAXES. There, we said it. Unfortunately, everyone has to pay taxes to the United States government – including those among us who are self-employed.
The funds we pay in taxes help keep the country and state running. That doesn’t mean we like it, however. This means that we’re all fighting a constant battle with the taxman, negotiating and deducting our way to a better deal. The end goal is to pay the least amount of taxes via the various loopholes, strategies, and tax credits available to us.
For most people, their salary or hourly wage is never what ends up in their pocket. Employers cut taxes from paychecks to go into Medicare and Social Security – even those in the lowest tax brackets who receive full refunds come April 15.
Those who are working for themselves have to pay taxes, too – specifically, self-employment tax.
What is Self-Employment Tax?
This is the imposed tax any small business owner or freelancer must pay to the United States government to fund Medicare and Social Security. If your income or net earnings over the course of a year exceed $400, then you, too, will be subject to this tax.
In other words, if you consider yourself self-employed, you pay self-employment tax. Any person in the following categories could be subject to this:
- Sole proprietors
- Independent contractors
- Member of a partnership
- Any person involved in trade or business for themselves
The Internal Revenue Service sometimes also considers self-employment for those that are members of a corporation that run their own business.
How Does Self-Employment Tax Work?
In every business, the employee and the company are both taxed to fund the aforementioned programs—Medicare and Social Security. Since a self-employed individual is both the business owner (employer) and the worker (employee), they have to pay both halves.
Current Tax Rates
As of 2018, the Social Security tax comes in at 6.2% for employee and 6.2% for employer; or 12.4% for a self-employed individual. Furthermore, as of 2020, Social Security tax is only applied to the first $137,700 of self-employment income. This makes the maximum Social Security tax cap $17,075.
As it comes to the Medicare tax, it costs 1.45% for each the employee and employer; or 2.9% for a self-employed individual. As of 2020, there is no maximum cap on self-employment Medicare payments.
This makes the total self-employment tax rate equal to Medicare tax (2.9%) plus Social Security tax (12.4%). As of 2020, then, the total self-employment tax is 15.3%.
Let’s say that you have a net income of exactly $137,700 and you’re self-employed. Under current law, you would pay $137,700 x 15.3% = $21,068 in self-employment taxes.
It’s also important to note that if your self-employment income is above $200,000 ($250,000 for married couples), then your Medicare tax increase by another 0.9%, making your total self-employment tax about 16.2%.
Although Medicare tax increase as net income increase, Social Security tax does not change. It caps at $137,700 (called a phase out).
While certainly no one likes paying taxes, if you want Social Security benefits when you retire, you MUST pay self-employment tax! Therefore, it’s important to keep careful records and pay the man when it’s time to file your tax return – lest you regret your oversight come retirement.
Taking a Tax Deduction
That’s right – self-employment tax is also eligible as a business deduction!
The Internal Revenue Service lets you take a deduction on the employer portion of the self-employment tax as a business expense. Your employer does this as well, but since you are the employer AND the employee, you get to take a deduction on the employer part.
In most cases, this is 7.65% (calculated as half of 15.3%).
Therefore, the actual cost of your self-employment taxes is 7.65% of your income (unless you make more than the threshold for the Medicaid tax increase).
Time for An Example
Let’s consider Sally Selfer, a single woman who runs a technology company. She brings in a net income of $200,000 a year after deducting business expenses.
So, what will her taxes look like?
As we previously mentioned, Sally is able to deduct the employer portion (7.65%) of her tax rate. Therefore, she ends up paying self-employment taxes on 92.35% of her income, instead of 100%.
To calculate the amount of her income eligible for Social Security taxes, then, we take 92.35% x $200,000 – $184,700. However, this amount is above the cap for Social Security payments. So, Sally only has to pay the maximum limit of $17,075 for the Social Security portion of her taxes.
Now, let’s cover the Medicare portion of her taxes.
Because Medicare payments do not have a cap, Sally has to pay the 2.9% rate on the full $184,700 of her taxable income. (This number has already been adjusted for the employer deduction, as shown above.) Therefore, $184,700 x 2.9% = $5,356 for the Medicare portion of Sally’s self-employment taxes.
When we add it all together, Sally’s self-employment taxes come out to $17,075 + $5,356 = $22,431.
But! We aren’t done yet. Because Sally is self-employed, she can take an above-the-line deduction for half of her taxes. As such, we divide $22,431 by 2 to get $11,216 in taxes for Sally in 2020.
How Do Self-Employers Pay Their Taxes?
Workers who are self-employed are not subject to withholding tax, which is the amount that employers withhold from their employees’ wages to pay directly to the government.
Instead, the Internal Revenue Service (IRS) requires that self-employed taxpayers make an estimated tax payment every 3 months to cover their obligations. The full year’s payments are then computed and reported on IRS Form 1040 come tax return season.
A Final Word: Key Notes
Social Security and Medicare/Payroll taxes fund the retirement, disability, and survivorship benefits that millions of Americans receive each year from the Social Security Administration.
If you are self-employed, you are the employee AND the employer, so you have to pay both portions of Social Security and Medicare taxes. However, you don’t have to make any payments until you make over $400 per year.
The good news is that you can take a business deduction on the employer portion of the self-employment tax.
The bad news is…nobody likes tax.