Self Employment Tax: An Obligation For Owners
In this post, we’ll explain what self-employment tax is and everything else you need to know about the subject.
What is Self-Employment Tax?
First, what is the self-employment tax? According to the IRS, self-employment tax consists of Social Security and Medicare taxes. It’s a tax that’s meant for people who earn income that isn’t subject to withholding.
This tax is similar to the Medicare and Social Security taxes that wage earners have withheld from their paychecks.
However, wage earners only pay the employee-equivalent portion of the SE tax. Owners are responsible for both the employee and employer-equivalent portion of SE tax.
In other words, as an owner, you pay Social Security and Medicare tax as an employee and an employer. This is what’s known as the self-employment tax.
In addition, since you—as a business owner—don’t have taxes withheld, you’re responsible for paying these taxes at tax time. An employee usually doesn’t have to worry about this tax as the payment is taken out from each paycheck automatically.
As of 2020, the self-employment tax rate is 15.3 percent. This total is made up of two parts, 12.4 percent for Social Security and 2.9 percent for Medicare.
If you’ve earned income and paid taxes on it, you’ve paid into Social Security. Social Security is a program administered by the federal government. It’s designed to provide a source of income for retired or disabled people. It also supports your dependents if you die.
Social Security is funded through taxes on employees and the self-employed. As a self-employed person, your social security tax rate is 12.4 percent. This tax makes up one part of your SE tax.
However, any amount you earn above $132,900 may not be subject to the Social Security part of your SE tax.
Medicare is a federal health insurance program designed for the elderly and disabled. It covers a variety of different kinds of health-related expenses.
The 2.9 percent Medicare tax is rolled into your SE tax. Unlike the Social Security portion, the Medicare tax is due on all your net earnings. There’s no cap.
In addition, for some people, there’s an additional Medicare tax rate of 0.9 percent.
This additional tax applies to certain amounts of self-employment income after December 31st, 2012. The threshold amounts that may make you liable for this additional tax are provided by the IRS.
Reporting Self-Employment Tax
Any self-employed person who will owe $500 or more when filing taxes must pay the SE tax. You can get a rough estimate of your tax obligation using a self-employment tax calculator like this one.
To precisely calculate your self-employment tax, you’ll need Schedule SE (Form 1040). This form gives the Social Security Administration the information they need to determine your benefits.
The form also shows you how much you’re going to owe in self-employment taxes. You’ll fill in information such as net profit, SE tax deduction, and current Social Security benefits. Based on that information, the form will provide instructions on how to calculate your SE tax.
The form itself is available for download from the IRS website. To complete this form on your own, you can use the Form 1040 instructions. Just be sure that whichever form and instructions you use are the most recent versions. Tax laws change each year, and these changes may affect your calculations.
Also, you should consider working with a tax professional to help you report your self-employment income. Not only will experts save you time, but they can also save you money on your final tax bill.
Plus, with SE tax, there are several exceptions and special considerations. Only a tax professional can talk you through these scenarios and the potential reporting requirements.
Deductions and Reductions
There are a few different ways you can lower the amount of SE tax you pay. The first two ways are provided to you by the IRS in the form of an income tax deduction and reduction. For the deduction, the IRS allows you to claim 50 percent of your self-employment as an expense.
Therefore, if you make $100,000 per year and your SE tax is $15,000, you can deduct $7500 from your taxable income. You make this adjustment on Form 1040 and it reduces your taxable income which results in lower taxes.
The other reduction you get is based on the way the tax itself is calculated. When you calculate your self-employment income, you get to deduct half the SE tax.
This reduces the amount of earnings that are subject to the SE tax, so if your self-employment income is $100,000 and your SE tax is $15,000, you’d reduce your income by $7500. That would put your income at $92,000 and you’d apply your income tax rate at that amount.
Beyond those built-in deductions of the SE tax, you can save on this tax by using other income deductions.
Self-Employment Tax Example
We’ll go through a simple, self-employment tax calculation example to illustrate the concepts we’ve talked about. Just remember, everyone’s tax scenario is unique. You’ll want to understand all applicable exceptions based on your situation. This example is purely educational.
To make things simple, let’s assume you made $100,000 in net profit during 2019. Depending on how you report your income, you’d find these earnings numbers on Schedule C or Schedule K-1.
You’d then take that $100,000 amount and multiply it by the SE tax rate of 15.3 percent. That calculation would come out to $15,300.
From that $15,300, you subtract half of the self-employment tax and that’s your SE tax. In this case, half would be $7650, so you’d owe $7650 in SE tax. This is the number you’d include on Form 1040.
Finally, depending on how you report income, you’d take half of your SE tax and subtract it from your taxable income.
In this example, that would reduce your income by $7650 to $92,350. If your tax rate was, say 24 percent, this would reduce your tax bill by $1836. In the end, you’d pay the net amount of $5814 due to the self-employment tax.
This is a very simple example of self-employment tax. The way you calculate it may be different. For example, if you’ve received social security or disability benefits, your calculation will change.
Also, if you report more than $132,900 in net earnings, you may be subject to additional Medicare tax. However, any income you make over $132,900 isn’t subject to the Social Security tax.
So, for example, if you make $133,000, you’d pay 15.3 percent on $132,900. On the remaining $100, you’d pay just 2.9 percent, which is the amount of the Medicare tax.
Are you Required to File Estimated Taxes?
In the United States, the tax system is “pay as you go.”
In other words, you must pay taxes as you earn income. How you pay those taxes, though, will vary based on whether you’re an employee or a self-employed earner.
Self-employed earners must generally make estimated tax payments in four payment periods. However, not every person that earns money from self-employment must pay estimated taxes.
Sole proprietors, partners, and S corp shareholders must pay if they expect to owe $1000 or more at tax time. Similarly, corporations must pay estimated taxes if they expect to owe $500 or more when they file taxes.
It’s important to note that estimated tax isn’t only applicable to self-employed earners. You may need to pay estimated tax on any income that isn’t subject to withholding, such as dividends or rent.
If you need to pay estimated tax, use Form 1040-ES to figure out how much to pay.
It’s important to take your estimated tax payments seriously. Underpayment penalties can be very expensive. Plus, if you have volatile income, you may need to annualize your income to avoid penalties.
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