Self-Employment Tax 101
What is self-employment tax?
Self-employment tax (SE tax) is the Social Security and Medicare tax paid by you: a self-employed individual. Self-employment tax applies to your net earnings – your profit (revenue minus expenses). In a typical job, half of Social Security and Medicare costs are covered by the employer while you pay the remaining half.
As a self-employed individual, this entire bill falls on you. Although mostly every worker pays into social security + medicare, for the sake of simplicity, this article is focused on the self-employed.
Who has to pay self-employment tax?
Any self-employed person who has a profit-earning of $400 or more annually must pay self-employment tax. This applies to freelancers, independent contractors, sole proprietors, LLC members, and partnerships. Basically, any business owner that is unincorporated.
Self-employment tax rates for 2021-2022
The self-employment tax rate is 15.3% Of that amount, 12.4% is for Social Security and the remaining 2.9% goes towards Medicare.
How do I calculate self-employment tax?
Look, I’m not gonna make this complex for you. Therefore I’m not going to spit out income limits and other tax law jargon when it comes to figuring out how much of your earnings are subject to SE tax. If you want to bombard yourself with the complexities of it all, then here’s an IRS article to digest if you insist.
But for the rest of us, we just want the important stuff.
This is what you need to know: Whenever you are setting aside money from your profit for quarterly estimated income tax purposes, add an extra 15.3% to that number. For example, if you estimate your profit to be $50,000, you may set aside an arbitrary amount such as 25% to cover your income taxes. So, you put $12,500 in a separate bank account that you opened specifically for taxes.
First of all, great job on having a bank account dedicated to tax payments! You’re going to want to add 15.3% to that 25% which brings you to 40% or $20,000 in estimated total taxes which is composed of $12,500 for income tax + $7,500 for SE tax.
Now that’s the super-high level way to do it if you still DIY with your taxes. Ideally, you work with your lovely tax professional who can take care of these vital matters for you.
How do I avoid or reduce self-employment tax?
Since you’re fronting this entire tax bill, you might cringe at the idea of paying an additional 15.3% of your hard-earned income on SE tax. Yep, that 15.3% SE tax is on top of what you pay in income tax which can be upwards of 50% when you consider Federal + state (we Californians & New Yorkers know this heavy tax burden all too well smh).
- Track all business expenses
The good news for self-employed individuals is that there are MANY tax deductions you can take advantage of. Business purchases like home office expenses and tech costs can all be deducted! Click here to read my list of 12 Tax Deductions & Benefits for the Self-Employed.
- Take the above-the-line deduction
You are able to deduct half of your self-employment tax. This tax write-off reduces your adjusted gross income which is why it’s considered an above-the-line deduction. This deduction mirrors the employer’s portions of Social Security and Medicare that would be paid by a typical boss. But since you are your own boss, you get to deduct half of the SE tax you’ve paid.
How to do this? As long as you or your tax professional use a tax software to prepare your tax returns, then there is nothing to worry about. The software will automatically apply the SE Tax deduction to your tax return. Easy peasy!
- Make an S-corp selection
LLC members have the luxury of this option. As an LLC member, you can reduce your self-employment tax by electing to have your LLC taxed as an S-corp. The reason for this is because S-corp owners pay half of the Social Security and Medicare taxes on their salary while the company pays the other half. This can be a tax strategy that can save you 5 or 6 figures in taxes…every year. I recommend you talk to your Accountant to learn if it makes sense for you to make an S-election.
You didn’t get into business because you want to do your own taxes… but taxes are part of that entrepreneur life and cannot be ignored. That’s why I’m here to help!