Is there a difference in taxes when you are self-employed?
As an employee, you may have noticed that your paycheck never matches your full salary. This is because your employer has to withhold certain payroll taxes. You might think that you wouldn't have to worry about those payroll taxes if you worked for yourself. But that's not the case – you'd still have to pay a 15.3% self-employment tax. What is this tax and why do you have to pay it? If you need help with this or any other tax
Self-Employment Tax Definition
In 1935, the federal government passed the Federal Insurance Contribution Act (FICA), which established taxes to help fund Social Security and Medicare. The FICA tax is 15.3%, paid by employers and employees, who split the burden by each paying half. Employers pay 7.65%, and their employees pay 7.65%.
To ensure that self-employed individuals still contribute toward Social Security and Medicare, the federal government passed the Self-Employed Contributions Act (SECA) in 1954. SECA established that without employers paying half the tax, self-employed individuals would pay the whole 15.3%. This tax paid by self-employed individuals is known as the SECA, or more simply, the self-employment tax.
Self-Employment Tax Calculation
The total self-employment tax is 15.3% of your net earnings and consists of two parts. The first part is Social Security at 12.4%. The law sets a maximum amount of net earnings that are subject to the Social Security tax. Anything over that amount is not subject to the tax. The maximum amount may change annually and has steadily increased over time. It is $132,900 for the 2019 tax year (and $137,700 for 2020).
Let's say you have $150,000 of net earnings from self-employment in 2019. You will pay a 12.4% tax on the first $132,900. However, you do not have to pay any Social Security tax on the remaining $17,100.
The second portion of your self-employment tax goes to Medicare. The rate for Medicare lands at 2.9%. Unlike with Social Security, the Medicare tax applies to all of your net earnings regardless of how much you earn. If you have $150,000 of net earnings as in the previous example, you must pay the 2.9% Medicare tax on the entire $150,000.
Since 2013 under the Affordable Care Act (ACA), there is an additional 0.9% Medicare surtax on income over a threshold. The threshold is $200,000 for individuals filing as single, $250,000 for married couples filing jointly and $125,000 for married couples filing separately.
So if you file as single and earn $250,000 over the year, the first $200,000 is subject to the 2.9% Medicare tax. The remaining $50,000 is subject to the 0.9% surtax for a total tax of 3.8%.
Self-Employment Tax: Who Needs to Pay
As a rule, you need to pay self-employment tax if your net earnings from self-employment are at least $400 over the tax year. This includes individuals who have their own business, as well as independent contractors and freelancers. You do not need to pay self-employment tax on income that you earn from an employer if the employer withheld payroll taxes.
Other situations may require you to pay self-employment tax. For one, you still need to pay even if you are a U.S. citizen employed by a foreign government. You must also pay self-employment taxes if you earn more than $108.28 as an employee of a church. If you earn untaxed income in these situations and are unsure whether it's subject to self-employment tax, it's best to visit the IRS website or seek professional help.
To review, if you work a full-time job that has payroll taxes deducted, but then you earn $1,000 through freelance work, you have to pay self-employment tax on the net earnings from that $1,000 (unless the net is under $400).
Additionally, the self-employment tax applies no matter how old you are. If you meet the above requirements and are already receiving Medicare and Social Security benefits, you will still have to pay the tax.
What Are Net Earnings?
The 15.3% tax seems high, but the good news is that you only pay self-employment tax on net earnings. This means that you can first subtract any deductions, such as business expenses, from your gross earnings.
One available deduction is half of the Social Security and Medicare taxes. That's right, and the IRS considers the employer portion of the self-employment tax (7.65%) as a deductible expense. Only 92.35% of your net earnings (gross earnings minus any deductions) are subject to self-employment tax. There are many other tax deductions that self-employed individuals can claim to reduce their taxable earnings, like if you use your home for business.
Let's say you earn $1,500 from a freelance job and claim $500 in deductions. You would then multiply the net $1,000 ($1,500 minus $500) by 92.35% to determine your taxable earnings. In this example, only $923.50 ($1,000 multiplied by 92.35%) is subject to self-employment tax.
Self-Employment Tax Filing
When filing your annual return, use Schedule C of Form 1040 to calculate your net self-employment income. If your business expenses come out to $5,000 or less, you may be able to file Schedule C-EZ instead of Schedule C.
The Schedule C or Schedule C-EZ will give you your calculated income or loss. This number will then be used on Schedule SE (Form 1040), Self-Employment Tax to calculate how much self-employment tax you should have paid throughout the year.
If you file a joint return with another self-employed person, you must calculate your self-employment taxes separately. The SECA does not allow joint filers to merge their incomes. Again, you will want to check out IRS instructions or seek professional financial help to ensure you file your taxes correctly.
In addition to filing an annual tax return, you generally have to make quarterly estimated tax payments if you are self-employed. Estimated tax is used for the self-employed since there is no employer to withhold the taxes. To file these quarterly payments, you use Form 1040-ES, Estimated Tax for Individuals. You will need your annual tax return from the previous year to fill out this form correctly. Filling out the form's worksheet will determine whether you need to file quarterly estimated tax.
To make your quarterly payments, you can use the Electronic Federal Tax Payment System, or you may mail in blank vouchers found in Form 1040-ES. The first instalment of estimated taxes for the tax year 2020 is due July 15, 2020 (extended from April due to the coronavirus crisis.)
Self-employed tax obligations
Self-employed individuals, including freelancers, must take their taxes into account when setting their pricing, consider their tax burden in planning their finances for the year (e.g., saving money vs. reinvesting it in the business) and track their business expenses to deduct them at the end of the year, Deutschkron said.
The IRS classifies self-employed individuals into the following categories:
- Carrying on a trade or business as a sole proprietor or an independent contractor
- Being a member of a partnership that carries on a trade or business
- Being otherwise in business for yourself (including a part-time business)
The basics for filing self-employment taxes
Before you can determine your tax obligations, know your tax rate and consider whether your region requires separate city taxes. To figure out your rate, first, calculate your net profit or net loss from your business. You can calculate this by subtracting business expenses from your business income. If your expenses are less than your income, the difference is net profit and is part of your income. If your expenses are more than your income, the difference is your net loss.
To prepare to file your taxes, you must first understand your tax rate, as well as any state and local taxes that might apply to you. To determine your tax rate, you must first figure out your net profit or loss during the taxable period.
Next, if your earnings from self-employment exceed $400, you must file a Schedule C (Form 1040). Even if your net earnings from self-employment were less than $400, you still have to file a return if you meet any of the other requirements listed in Form 1040.
According to the IRS, self-employed taxpayers who expect to owe more than $1,000 in self-employment tax must make estimated tax payments four times during the year. You will need to use IRS Form 1040 to file these quarterly taxes.
You can estimate your expected self-employment tax using free tools like this one from QuickBooks or this one from TaxAct.
How to calculate your self-employment tax
The self-employment tax rate for 2019 is 15.3%, which encompasses the 12.4% Social Security tax and the 2.9% Medicare tax. Self-employment tax applies to your net earnings. For 2019, only the first $132,900 of your earnings is subject to Social Security tax (this amount increases to $137,700 in 2020). Still, a 0.9% additional Medicare tax may also apply to your self-employment earnings if they exceed $200,000 if you're a single filer, or $250,000 if you're filing jointly.
As mentioned earlier, to accurately calculate your self-employment tax, you need to calculate your net self-employment earnings for the year — which is your self-employment gross income minus your business expenses. Typically, 92.35% of your self-employment net earnings are subject to self-employment tax. Once you have your total net earnings from self-employment that are subject to tax, apply the 15.3% tax rate to determine your total self-employment tax.
If you've had a loss or just a little bit of income from self-employment for the year, there are two optional methods to calculate net earnings in the IRS Schedule SE.
How to file your taxes
If you expect to make quarterly estimated tax payments, use Form 1040-ES, Estimated Tax for Individuals, which contains a worksheet similar to Form 1040. Keep your return – you will need the prior year's return to fill out Form 1040-ES.
You can use the blank vouchers that are included with Form 1040-ES to mail your estimated tax payments, or you can pay online using the Electronic Federal Tax Payment System (EFTPS). If this is the first year you're self-employed, you will need to estimate the amount of income you expect to earn for the year. See the IRS's Estimated Taxes page for more information.
To file your annual return, you will need to report your income (or loss) from a business you operated or a profession you practised as a sole proprietor. To report your Social Security and Medicare taxes, you must file Schedule SE (Form 1040), Self-Employment Tax.
Use the income or loss calculated on Schedule C or Schedule C-EZ to determine the amount of Social Security and Medicare taxes you should have paid during the year. The instructions for Schedule SE may help fill out the form.
Ways to save on taxes
If you're transitioning from a full-time position, it's important to pinpoint write-offs. Here are six ways to write off taxes:
- Startup costs: If you recently started a new business, you can deduct the startup costs from your tax bill. These include legal fees, marketing costs and more.
- Vehicle expenses: You can deduct up to $25,000 in vehicle expenses in addition to the mileage deduction for travel expenses.
- Home office deduction: You can deduct your home office if you maintain a space dedicated to work tasks only. To do so, measure the square footage of your home office to determine how much you can deduct for rent or mortgage payments, utilities and property taxes.
- Supplies and equipment: Any office supplies or equipment necessary for the functioning of your job can be deducted from your taxes.
- Social Security and Medicare taxes: Just like other employers, self-employed people must pay the full Social Security and Medicare tax. However, they can write off half of it at the end of the year.
- Health insurance premiums: If you are self-employed, you might be eligible to deduct healthcare costs for you and your family from your taxes.
Tax software can help you pinpoint write-offs you might otherwise miss, streamline the filing process and more easily identify your tax rate. It also saves your returns, and, if nothing major changes, you can transfer last year's tax info to the new tax year.
Tax deductions and tax credits
When you're looking for ways to save on your taxes, you might automatically jump to tax deductions and tax credits. But do you know the difference between the two? According to H&R Block, tax credits directly decrease the amount of taxes you owe, while tax deductions lower the overall amount of your taxable income.
Since deductions lower your taxable income, they also lower the amount of taxes you owe by decreasing your tax bracket, not by lowering your actual taxes. There are standard deductions and itemized deductions:
- Almost everyone qualifies for the standard tax deduction – the deduction amount varies based on your filing status (e.g., single, married filing jointly, married filing separately, or head of household), but everyone with the same filing status receives the same standard deduction amount.
- There are many possible itemized deductions, and the deduction amounts vary by individual. These are some of the most common itemized deductions:
- Certain medical and dental expenses above 7.5% of your adjusted gross income
- State income taxes
- State sales and local tax
- Property taxes
- Charitable contributions
- Mortgage interest
- Student loan interest
When to pay self-employment tax
If you had self-employment income earnings of $400 or more during the year, you are required to pay self-employment taxes and file Schedule SE with your Form 1040, which is generally due by April 15 (now July 15, 2020). However, if you expect to owe $1,000 or more in combined income tax and self-employment taxes, you'll need to make estimated quarterly tax payments.
Estimated payments are due on April 15 (now July 15 for 2020), June 15, September 15, and January 15 of the following year. Those dates shift to the next business day if the 15 falls on a weekend or holiday.
You can estimate the amount you need to pay using the worksheet on page 8 of Form 1040-ES. The form will help you determine the amount you'll owe for the year, divide it by four, and pay in equal instalments by the due dates mentioned above. The form also includes vouchers to include when mailing your payment. If you prefer to pay online using IRS Direct Pay, you won't need a voucher (or a stamp).
You can also use our free estimated tax calculator to figure out how much-estimated tax you'll owe.
How to avoid or reduce self-employment tax
Many new business owners cringe at the idea of paying an additional 15.3% of their hard-earned cash into self-employment taxes. The good news is, there are ways to reduce the amount you owe.
- Track all business expenses. Since self-employment taxes applied to net earnings rather than your gross income, deductible business expenses will reduce the amount you owe. Be sure to track and take advantage of all tax deductions.
- Take an above-the-line deduction. The tax code allows self-employed people to deduct half of their total self-employment tax as an above-the-line deduction. This deduction mirrors the employer portion of Social Security and Medicare that would be paid by your boss if you worked for someone else. Take your calculated self-employment tax and divide it in half. The result goes on line 14 of Schedule 1 attached to your Form 1040.
- Make an S-corp election. Some LLC members can reduce their self-employment tax burden by electing to have their LLC taxed like an S corporation. This is because S corp owners pay Social Security and Medicare taxes only on their salary, which LLC members pay self-employment taxes on 100% of their share of the LLC's profits. However, making an S corp election isn't right for everyone. Talk to a tax professional to determine whether it's the right move for you.
Make your super count
Superannuation may not be at the top of your list when you're starting out by yourself. But it's important to think about it early. Super is a tax-efficient way of saving money to live on when you stop working.
Since you won't get regular super contributions from an employer, it's up to you to make them yourself. As well as investing for your future, adding to your super can reduce the tax on your current income. You may also be eligible for the government super co-contribution.
See super for self-employed people for more information.
Protect your income — and your business
Without sick leave, getting sick or injured can mean financial difficulties. Income protection insurance can help you pay your bills if you can't work.
If you have a super fund, find out whether they offer income protection insurance as part of the package.
Consider other types of insurance that can protect you and your business, such as public liability insurance and workers compensation insurance. See business.gov.au for information about insurance for business.
The mileage deduction
Taking advantage of the mileage deduction is a great way to lower your self-employment tax bill. You can only use the mileage deduction for business trips. But, these can add up if you keep track or every drive.
Business driving includes travel between offices, driving for business-related errands, visiting customers, entertaining customers and more. Driving from your house to an office is considered commuting. This is never deductible, even if you're doing work during the trip.
There are two ways to claim the business mileage deduction: using the standard mileage rate or the actual expense method. The standard mileage rate means you multiply the number of business miles by the rate set by the IRS to find your deduction.
The actual expense method requires keeping track of the costs for your car. This includes gas, insurance, tires, depreciation and more.
The standard mileage rate is far simpler, and most tax experts recommend using this for the first year of a car's business usage. You can always switch to the actual expense method the year after. And then, you can switch between the two in later years. If you start with the actual expense method, you're not allowed to switch to the standard mileage rate.
Self-employment tax ensures that self-employed individuals make the same contribution and receive the same value of benefits as salaried individuals. The 15.3% may shock those who are newly self-employed. But when all is said and done, tax deductions can save you from paying the entire tax.
Don't forget that without an employer, you will have to do a lot of the tax math yourself. If you find yourself overwhelmed or confused by the forms and regulations, you may benefit from professional tax help.