Being self-employed is awesome. You enjoy more control over your work-life balance, choose your hours, and have more say in the people and clients you work with. But before you hand in your letter of resignation, you need to understand the challenges of being self-employed. More specifically, you need to consider self-employment tax.
Like most tax rules, self-employment tax may seem incomprehensible at first. But take the time to read up on the subject, and you just might find that getting a handle on this aspect of self-employment is easier than you think.
What Is Self-Employment Tax?
If you have a job, you’re familiar with the Social Security tax and Medicare taxes, commonly called FICA taxes, which your employer withholds from each paycheck. Self-employment taxes are the equivalent of Social Security and Medicare taxes for the self-employed. If you’re a freelancer, independent contractor, or small-business owner, you don’t have an employer to withhold these taxes for you, so you’re responsible for paying them on your own.
If you had self-employment income of $400 or more during the tax year, you’re required to calculate self-employment taxes and file Schedule SE attached to your individual tax return, Form 1040.
The Self-Employment Tax Rate
The self-employment tax rate is currently 15.3%. This rate includes two components: 2.9% for Medicare and 12.4% for Social Security.
There’s no limit to the amount of your net earnings from self-employment that’s subject to the Medicare portion of the self-employment tax, but there is a cap on the Social Security portion. This cap is called the Social Security wage base, and it changes every year. For the tax year 2020, the Social Security wage base is $137,700. For 2021, it rises to $142,800.
When you work for an employer, your employer withholds half of these amounts from your paycheck — 1.45% of your wages for Medicare and 6.2% for Social Security — and matches the other half on your behalf. As a self-employed taxpayer, you’re responsible for the full tax. However, you can deduct half of your self-employment tax as an adjustment to your gross income on Line 14 of Schedule 1.
In addition to the 2.9% Medicare tax, high earners pay an additional Medicare tax of 0.9% on income above the following thresholds:
|Married filing jointly||$250,000|
|Married filing separate||$125,000|
|Head of household||$200,000|
How to Pay Self-Employment Tax
Now that you have an understanding of self-employment tax basics, you need to know how to pay the taxes you owe.
Like federal income taxes, self-employment taxes are a pay-as-you-go system. That’s why employers withhold federal and state income taxes and FICA taxes from each paycheck rather than having you write a big check to the IRS at the end of the year with your tax return. When you’re self-employed, you’re required to make quarterly estimated payments if you owe taxes of $1,000 or more.
IRS Form 1040-ES includes a worksheet on Page 6 for calculating your estimated self-employment tax, as well as your deduction for one-half of your self-employment taxes. You can use Form 1040-ES to calculate both your estimated self-employment tax and estimated income tax for the year, divide them by four, and pay them in four equal installments. Those installments are due on April 15, June 15, September 15, and January 15 of the following year. These due dates move to the following business day if the 15th falls on a weekend or holiday.
You can make your quarterly estimated payments online using IRS Direct Pay or by mailing a check with the vouchers included with Form 1040-ES.
When you file your tax return at the end of the year, you’ll reconcile the total amount of estimated tax payments you made with the amount of income and self-employment taxes you owe. If you paid too much, you can choose whether to have your overpayment refunded to you or applied to next year’s estimated payments. If you paid too little, you’ll have to pay the difference, and you might also be charged an underpayment penalty.
What Happens If You Don’t Pay Self-Employment Taxes on Time?
If you owe at least $1,000 in combined income and self-employment taxes for the year and don’t make quarterly estimated payments, the IRS will assess a penalty for underpayment of estimated tax when you file your tax return.
The IRS calculates the underpayment penalty by first calculating how much you should have paid for each of the four quarterly installments. Next, the difference between what you paid and what you should have paid is multiplied by the effective interest rate for the period. The effective interest rate is set quarterly. For the first quarter of 2021, that interest rate is 3%.
The penalty is calculated separately for each installment, so you may be charged a penalty for one quarter but not the others.
How to Reduce Your Self-Employment Taxes
Self-employed individuals have a lot of opportunities to reduce their tax bill through tax deductions. The more deductions you have, the lower your net income — and thus your self-employment tax — will be.
In order to qualify for a deduction, your business expenses must be both ordinary and necessary. Ordinary expenses are common and accepted in your trade or business; necessary expenses are helpful and appropriate for your business.
The kinds of expenses that are ordinary and necessary for your business depend on the type of business you’re in. Some common ones include:
- Auto expenses
- Credit card merchant fees
- Dues and membership fees
- Home office expenses
- Legal and professional fees
- Office expenses
- Rent or lease payments
- Repairs and maintenance
- Taxes and licenses
- Telephone and cellphone service
For more details on common business expenses and what is and is not deductible on Schedule C, check out IRS Publication 535.
Before you go on a spending spree to avoid taxes, remember that you don’t get a dollar-for-dollar reduction in your taxes for every dollar you spend. Unless the expense is something you actually need for your business, it’s not a smart move to spend money simply to lower your tax bill.
For example, say you’re considering spending $1,000 on a new laptop. If you’re in the 24% tax bracket, spending $1,000 will save you about $240 in taxes. If you need a new laptop, spending the money may be a smart move. But if you’re spending $1,000 to avoid paying $240 in taxes, you’re better off keeping the $1,000 in your pocket.
Consider self-employment tax just another cost of doing business. Owing taxes means you’re making money. So while every smart business owner wants to do what they legally can to lower their tax bill, spending money unnecessarily isn’t the answer.
If you’re still confused about self-employment tax, it’s time to get in touch with a professional, such as a CPA or Enrolled Agent. You can locate one in your area through H&R Block. If you’re new to the world of self-employment, a tax pro can answer any question you have, help you estimate your self-employment taxes, and give you smart ideas for lowering your tax bill.
So add those tax due dates on your calendar and come up with a plan to estimate and pay your self-employment taxes. It’s an important part of being your own boss.