What Is Self-employment tax?
Self-employment tax is a federal tax comprising Social Security and Medicare taxes, primarily levied on individuals who work for themselves rather than for an employer. This essential component of personal taxation ensures that self-employed individuals contribute to the same social insurance programs that traditional employees and their employers fund through payroll taxes. The self-employment tax rate is a combined figure that covers both the employer and employee portions of these contributions. Individuals generally calculate this tax on their net earnings from self-employment, which are derived from their gross income after permissible deductions. It is a critical consideration for those determining their overall taxable income and subsequent tax liability.28, 29
History and Origin
The framework for self-employment tax in the United States emerged from the broader context of Social Security legislation. While the initial Social Security Act of 1935 focused on wage-earning employees, extending coverage to self-employed individuals was a later development. A significant turning point came with the Self-Employment Contributions Act (SECA) of 1954. This act mandated that most self-employed individuals earning at least $400 per year contribute to Social Security, reflecting a shift to include this segment of the workforce in the national social insurance system.27
Initially, the self-employment tax rate was considerably lower than it is today, set at 2.25% on income up to $3,600 from 1951 to 1953, meaning a maximum annual payment of $81.26 Over the decades, the rates gradually increased to align with the growing needs and expansions of the Social Security and Medicare programs. By 1990, the combined self-employment tax rate reached 15.3%, a rate which has largely remained consistent since then, apart from an additional Medicare tax for high-income earners introduced later.25 The extension of these contributions ensures that independent contractors and business owners build their own eligibility for future Social Security and Medicare benefits, similar to their traditionally employed counterparts.24
Key Takeaways
- Self-employment tax consists of contributions to Social Security and Medicare programs.
- It is paid by individuals who are self-employed, including sole proprietors, partners, and independent contractors.
- The current standard rate for self-employment tax is 15.3% on eligible net earnings from self-employment.
- Half of the self-employment tax paid is deductible for income tax purposes, which helps reduce the individual's overall adjusted gross income.
- Self-employed individuals are typically required to pay self-employment tax through estimated tax payments throughout the year.
Formula and Calculation
The self-employment tax is calculated on your net earnings from self-employment. Generally, 92.35% of your net earnings are subject to self-employment tax. The total self-employment tax rate is 15.3%, which comprises two parts: 12.4% for Social Security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).23
The formula for calculating self-employment tax is:
Where:
- Net Earnings from Self-Employment: This is your gross income from your trade or business minus allowable business expenses and deductions. This figure is typically calculated on Schedule C (Form 1040) for sole proprietors.22
- 0.9235 (or 92.35%): This represents the portion of your net earnings subject to self-employment tax. It accounts for a deduction similar to the employer's half of FICA taxes.
- 0.153 (or 15.3%): This is the combined Social Security and Medicare tax rate.
It's important to note that the Social Security portion (12.4%) of the tax is only applied to earnings up to an annual limit, which is adjusted for inflation each year. However, the Medicare portion (2.9%) applies to all net earnings from self-employment without an income limit.21 Additionally, high-income earners may be subject to an additional Medicare tax.20
Interpreting the Self-employment tax
The self-employment tax represents a significant financial responsibility for individuals operating as a sole proprietor, partner, or independent contractor. Understanding this tax is crucial for accurate financial planning and budgeting. Unlike traditional employees whose Social Security and Medicare contributions are withheld by their employers, self-employed individuals are solely responsible for calculating and paying both the employee and employer portions of these taxes.18, 19
The payment of self-employment tax directly contributes to an individual's eligibility for Social Security and Medicare benefits in retirement, disability, or for survivor benefits. Therefore, consistently meeting this tax liability ensures that one accrues sufficient work credits to qualify for these programs in the future. Proper interpretation also involves recognizing that half of the self-employment tax paid is deductible from your gross income when calculating your adjusted gross income for income tax purposes. This deduction effectively reduces your overall income tax burden, although it does not reduce the actual self-employment tax itself.16, 17
Hypothetical Example
Consider Sarah, a freelance graphic designer operating as a sole proprietor. In a given tax year, her business generates $60,000 in gross revenue. After deducting legitimate business expenses, such as software subscriptions, office supplies, and professional development, her net earnings from self-employment amount to $45,000.
To calculate her self-employment tax:
- Determine the portion subject to SE tax: $45,000 (net earnings) * 0.9235 = $41,557.50
- Calculate the Social Security portion (12.4%): $41,557.50 * 0.124 = $5,153.13
- Calculate the Medicare portion (2.9%): $41,557.50 * 0.029 = $1,205.17
- Total Self-Employment Tax: $5,153.13 + $1,205.17 = $6,358.30
Sarah would report her business income and expenses on Schedule C of her Form 1040, and then calculate her self-employment tax on Schedule SE. She can then deduct half of this $6,358.30 (i.e., $3,179.15) on her Form 1040 when calculating her adjusted gross income, which helps reduce her overall income tax.
Practical Applications
Self-employment tax has several practical applications across various aspects of financial planning and operations for independent professionals and small business owners.
- Financial Planning and Budgeting: For sole proprietors and partnerships, accurately estimating and budgeting for self-employment tax is crucial. This helps prevent underpayment penalties and ensures sufficient funds are set aside for tax obligations. Since employers do not withhold these taxes, individuals must proactively manage their tax savings.14, 15
- Estimated Tax Payments: Self-employed individuals are generally required to pay their tax liability, including self-employment tax, through quarterly payments to the IRS.13 This helps distribute the tax burden throughout the year, rather than facing a large sum at year-end.
- Business Structure Decisions: Understanding self-employment tax implications can influence decisions about business structure. For instance, forming an S Corporation can sometimes alter how owner's income is treated, potentially reducing self-employment tax burden on distributions, though salary wages remain subject to FICA taxes.
- Deduction Planning: The ability to deduct one-half of self-employment tax from gross income provides a valuable tax benefit. This deduction is a key consideration in tax planning, as it directly reduces an individual's adjusted gross income and, consequently, their income tax.12
- Economic Impact and Trends: The prevalence and implications of self-employment tax also reflect broader economic trends. As the gig economy expands and more individuals engage in independent work, the self-employment tax becomes a more prominent feature of the overall tax landscape, affecting a growing segment of the workforce.11
Limitations and Criticisms
While self-employment tax serves the vital function of funding Social Security and Medicare for independent workers, it also presents certain limitations and has faced criticisms.
One primary criticism centers on the perception that self-employed individuals bear a disproportionately higher tax burden compared to traditional employees. This is because they are responsible for both the employee and employer portions of the FICA taxes (15.3%), whereas a traditional employee only pays 7.65%, with their employer covering the other half.10 Although self-employed individuals can deduct half of their self-employment tax for income tax purposes, the full 15.3% is still paid into the Social Security and Medicare systems based on their net earnings.9
Another limitation is the administrative burden on self-employed individuals. Unlike wage earners whose taxes are withheld automatically, independent contractors must proactively track their gross income, deductions, and accurately calculate their self-employment tax. This often necessitates meticulous record-keeping and potentially requires professional tax assistance, adding to overhead costs.8 Failure to properly calculate and remit quarterly payments can lead to penalties for underpayment.
For those with fluctuating income, managing self-employment tax obligations can be particularly challenging, as income streams may be unpredictable, making accurate estimated tax payments difficult to forecast.
Self-employment tax vs. Estimated tax
Self-employment tax and estimated tax are related but distinct concepts in U.S. taxation for independent workers. The self-employment tax specifically refers to the Social Security and Medicare contributions paid by individuals who work for themselves. It is the equivalent of the FICA taxes that are withheld from a traditional employee's paycheck, but for which self-employed individuals are solely responsible for both the employee and employer portions.6, 7
Estimated tax, on the other hand, is the method by which self-employed individuals (and others who don't have taxes withheld from their income) pay their income tax, self-employment tax, and other taxes throughout the year. It's not a type of tax itself, but rather a payment mechanism. Because no employer is withholding taxes, self-employed individuals must estimate their total annual [tax liability](https://diversification.com/term/tax liability)—which includes their self-employment tax, as well as regular income tax, and sometimes other taxes like the additional Medicare tax—and make quarterly payments to the IRS. So,5 while self-employment tax is a component of the overall tax bill, estimated tax is the system used to pay that bill periodically.
FAQs
Who has to pay self-employment tax?
Generally, you must pay self-employment tax if your net earnings from self-employment (gross income minus business expenses) are $400 or more in a tax year. This applies to sole proprietors, partners in a partnership, and independent contractors.
##4# What does self-employment tax cover?
Self-employment tax covers your contributions to Social Security and Medicare. These are the federal programs that provide retirement, disability, survivor benefits, and healthcare coverage.
##3# Is self-employment tax deductible?
Yes, you can deduct one-half of your self-employment tax when calculating your adjusted gross income for federal income tax purposes. This deduction reduces your overall taxable income but does not reduce the amount of self-employment tax you owe.
##2# How do I pay self-employment tax?
Self-employment tax is typically paid through estimated tax payments made quarterly throughout the tax year. You can use IRS Form 1040-ES to calculate and pay these amounts.
##1# What happens if I don't pay self-employment tax?
If you don't pay enough self-employment tax or other estimated tax throughout the year, you may be subject to penalties for underpayment when you file your annual tax return.