Self-employment tax refers to the federal tax that small business owners, freelancers, or any self-employed individuals pay to fund Social Security and Medicare. This tax is quite similar to FICA taxes that an employer pays. Typically, if you have net earnings of $400 that can include side hustles or contract work; you will pay self-employment tax which is more than Social Security & Medicare taxes. Moreover, the person whose self-employment income is less than it does not have to pay these taxes.
In this article, we’ll discuss self-employment tax in-depth and what it means for freelancers and self-employed individuals.
Understanding Self-employment Tax
Self-employment tax is applied on self-employment income, and it is a combination of Social Security plus Medicare taxes. The self-employment tax is usually more than these two taxes because employers have to pay more tax than their employees. As a freelancer or business owner, you are required to pay the total amount yourself.
The self-employment tax rate is 15.3%, with 12.4% Social Security and 2.9 percent Medicare Tax. Typically, a self-employed person with net earnings of $400 or more during the tax year must pay SE taxes to prove that you are not withheld from a paycheck. In addition, church employees with a net income of more than $108.28 also have to pay SE taxes.
Who has to pay self-employment tax?
According to Internal Revenue Service, the self-employment tax applies to the following categories of self-employed individuals.
- Independent contractors who work in a business, trade, or profession, including lawyers, doctors, accountants, and working with a ridesharing app or for food delivery.
- Solopreneurs who carry on unincorporated businesses.
- The partnership members or LLC (Limited Liability Company) who engage in business or trade.
- The workers in the company who are not classified as employees don’t get payments from the company and do not pay withholding taxes.
- All the individuals who work for themselves and earn a profit owe self-employment taxes.
Examples of Self-employment Tax
Self-employed individuals have to pay these taxes on 92.35% of their net income, not 100% of their earnings.
Let’s say you’re an independent contractor and earned $150,000 in the tax year. You have to pay $18,130 for payroll taxes, including $14,694 Social Security plus $3,436 Medicare taxes. However, if you work for an employer, he will pay half payroll tax, $9,065.
In addition, if the web developer earns $500 monthly by freelancing, they will get the entire income, so they must pay self-employment tax on this income.
How does Self-Employment Tax work?
Self-employment tax (SE) works by applying a 15.3% tax rate on 92.35% earnings of self-employed individuals. A self-employed person has to pay 12.4% Social Security tax which is assessed as a combination of 6.2% for the employee and 6.2% for the employer. So, an independent contractor or solopreneur pays these taxes as they are both employee and an employer. Moreover, the Social Security tax is just applied on the first self-employed income of $147,000 for a total tax of $18,228.
Additionally, sole proprietor or freelancer is taxed 2.9% Medicare taxes which is 1.45% for the employee & 1.45% for the employer. As the freelancer is both employee and employer, they will pay it. Unlike Social Security tax, Medicare taxes have no net earnings limit.
So, self-employment tax is 12.4% + 2.9% = 15.3%. An independent individual with a total income of $145,000 during the tax year would pay $18,850.0. ($145,000 x 15.3%).
How to pay Self-employment Tax?
To pay self-employment tax, first of all, use IRS Schedule C and SE to find your self-employed net income and how much tax you owe on this income. The Form 1040-ES of the IRS is used to pay taxes. You have to file taxes four times within a year before the deadlines set by Internal Revenue Service (IRS). The deadlines for this tax year are 18 April, 15 June, 15 September, and 17 January 2023.
However, the form has vouchers you can use while mailing the payment. But if you want to pay online, you can do using IRS Direct Pay, and there would be no need for a voucher for paying online.
Moreover, you must have an SSN, Social Security Number, and ITIN, an Individual taxpayer identification number, to pay self-employment tax. It is best to pay the taxes before these IRS deadlines; otherwise, you might have to pay late penalties.
Self-Employment Tax Deductions
You can deduct self-employment tax on your taxable income, and this deduction will only lower your taxable income, not the amount of taxes you owe & your actual earnings. So, you can deduct half of it from your adjusted gross income and lower your tax bracket because the amount of tax you owe will also get lower when taxable income decreases. For it, you might be eligible for the EITC, Earned Income Tax Credit if you fill a Form 1040 or 1040-SR Schedule C.
Bottom Line
Self-employment tax is equal to payroll taxes paid by employees & employers. Either you’re running a side hustle, an independent contractor or freelancer, or you owe self-employment tax. As a self-employed individual and business owner, it is essential to know how self-employment taxes work and how they can help you.
The key to being ready for the tax season and running a profitable business is keeping track of your expenses & income year-round. Do not wait for the deadlines to add up your taxes and calculate your income at the last minute. Track your finances & spending and grow your business to earn more profits.
