What is Self-employment tax ?

What is Self-employment tax ?

Self-employment tax (SE tax) is the Social Security and Medicare tax that people who work for themselves have to pay. It functions similarly to the FICA tax that employers withhold from employees’ paychecks as part of payroll taxes. However, unlike traditional employees, self-employed individuals are responsible for paying this tax on their own, as there is no employer to deduct it from their earnings

Do I have to pay self-employment tax?

All self-employed individuals are required to pay self-employment taxes on earnings of $400 or more. This obligation extends to anyone classified as self-employed, including seniors currently receiving Social Security benefits. According to the IRS, you are considered self-employed if you work as a freelancer, independent contractor, or if you own a business, whether it is a sole proprietorship or partnership.

 

How much is self-employment tax?

The self-employment tax rate is 15.3%, made up of 12.4% for Social Security and 2.9% for Medicare. However, the Social Security portion applies only to a portion of your business income due to the Social Security wage base limit.

For 2023, the Social Security wage base is $160,200, and it increases to $168,600 in 2024. This means that in 2023, the Social Security tax is only applied to the first $160,200 of your income from wages and self-employment. Any income beyond this threshold is not subject to additional Social Security tax. However, there is no limit on the Medicare portion of the self-employment tax, so regardless of your earnings, the Medicare tax applies to all your wages and self-employment income

For example, say you have a full-time job earning $160,000 for the tax year. You also have a side hustle making custom party cakes that brings in an additional $22,000 per year. In 2024, your employer withholds Social Security taxes on $160,000 of your wages. Since you’ve already reached the Social Security wage base for 2024, you wouldn’t have to pay the 12.4% Social Security portion of self-employment taxes on your side hustle income. You’d only have to pay the 2.9% Medicare portion of self-employment tax.

Additional Medicare tax

High-earning tax filers are also responsible for paying an additional Medicare tax of 0.9% on income above the following thresholds, depending on their filing status:

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How to calculate self-employment tax

To compute your self-employment tax, you first need to determine your net earnings from self-employment. This figure is derived by subtracting your business expenses from your total business income. Sole proprietors, independent contractors, and small business owners must complete a Schedule C as part of their IRS Form 1040 when filing their federal income taxes. The Schedule C form is essential for accurately reporting income and deductible expenses related to your business activities

If your net earnings from self-employment are below the Social Security wage base, calculating your tax is straightforward. However, if your earnings exceed the Social Security wage base, the calculation becomes more complex and requires additional steps. You can use our free self-employment tax calculator, or we can guide you through the process of calculating your tax, tailored to your specific situation.

If your net earnings fall under the Social Security wage base:

1. Calculate your self-employment taxable income.

Net income from self-employment in 2023 is $200,000.

Multiply $100,000 by 92.35%. (The reason for using 92.35% is because this figure reflects the deduction of 7.65%, which includes the employer’s share of FICA taxes that would typically be withheld if you were employed by a business.)

2. Calculate your self-employment taxes.

Then, multiply your taxable self-employment income by the 15.3% self-employment tax rate.

Your self-employment taxes are $28,259.1. The result is rounded because the IRS allows rounding off cents to whole dollars on tax returns and schedules.

1.If your net income falls below the Social Security wage limit:

Calculate your net income that is subject to self-employment tax.

Let’s say your net earnings from self-employment were $150,000 for 2022. Only $147,000 of your earnings are subject to Social Security taxes, so we have to add an extra step in the calculation.

Net earnings from self-employment were $150,000 for 2023.

$147,000 of your earnings are subject to Social Security taxes.

(so we have to add an extra step in the calculation.)

2. Calculate your self-employment taxes.

Next, multiply your taxable self-employment earnings by the individual rates for Social Security (12.4%) and Medicare (2.9%)

When to pay self-employment tax

If you earn $400 or more from self-employment in a year, you must pay self-employment taxes and include Schedule SE with your Form 1040 tax return, typically due by April 15. If you anticipate owing $1,000 or more in total income tax and self-employment taxes, you should make estimated quarterly tax payments.

Self-employed individuals are required to make estimated tax payments by April 15, June 15, September 15, and January 15 of the following year. If any of these dates fall on a weekend or holiday, the deadline shifts to the next business day.

To estimate the amount you need to pay, you can use the worksheet provided on page 8 of Form 1040-ES. This worksheet helps you calculate your projected annual tax liability. Once determined, you should divide this amount by four and remit equal instalments by the aforementioned due dates.

When mailing your payment, use the vouchers included with Form 1040-ES. Alternatively, if you opt to pay electronically through IRS Direct Pay, you can make payments conveniently without the need for a voucher or postage.

Is self-employment tax deductible?

Paying self-employment taxes entitles you to a tax deduction when filing your federal income taxes. You can deduct 50% of your self-employment tax amount from your adjusted gross income, reducing your overall taxable income and potentially lowering the amount of taxes you owe. For instance, if your calculated self-employment taxes amount to $2,000, you can deduct $1,000 from your taxable income. Depending on your tax bracket, this deduction can save you between $100 and $370 on your tax liability.

How to avoid or reduce self-employment tax

Many new business owners are wary of paying an extra 15.3% in self-employment taxes, but there are strategies to minimize your business tax burden.

·         Track all business expenses: - Because self-employment taxes are based on net earnings rather than gross income, you can lower your tax liability by deducting eligible business expenses. It’s important to meticulously track and utilize all available deductions and potentially beneficial tax credits. Certain deductions, such as those for a home office or health insurance, can provide significant savings.

·         Take an above-the-line deduction: - Self-employed individuals can deduct half of their self-employment tax as an above-the-line deduction. This deduction corresponds to the employer’s portion of Social Security and Medicare taxes. Simply divide your calculated self-employment tax by two and report the result on line 15 of Schedule 1 with your Form 1040.

·         Make an S-Corp election: - Switching your LLC to be taxed as an S corporation can potentially lower self-employment taxes for some members. This is because S Corp owners pay Social Security and Medicare taxes only on their salary, not on all profits. However, this election may not be suitable for everyone. Consult with a tax professional to assess whether it’s the best choice for your circumstances.