Term self employment tax

What Is Self-Employment Tax?

Self-employment tax is a mandatory contribution to the U.S. Social Security and Medicare programs for individuals who work for themselves, rather than for an employer. Falling under the broader financial category of taxation, this tax ensures that self-employed individuals contribute to these federal benefit programs, similar to how employees and their employers contribute through payroll tax withholdings. The self-employment tax covers benefits such as retirement, disability, survivor benefits, and hospital insurance. Generally, anyone who has net earnings from self-employment of $400 or more must pay this tax.²⁸,²⁷

History and Origin

The framework for what is now known as self-employment tax is rooted in the Social Security Act, which was signed into law on August 14, 1935.²⁶,²⁵ Initially, the Social Security program was financed through payroll taxes levied on employees and their employers, primarily covering workers in commerce and industry.²⁴ However, the original act did not include provisions for self-employed individuals to contribute to these social insurance programs.

The inclusion of self-employed individuals into the Social Security system came later, with amendments designed to expand coverage. This allowed independent workers, such as sole proprietors and independent contractors, to gain access to the same social security and medicare benefits as traditional employees. The self-employment tax was established to ensure that these individuals contribute their share for future benefits, mirroring the combined employee and employer contributions.

Key Takeaways

• Self-employment tax consists of Social Security and Medicare taxes paid by individuals who work for themselves.
• The tax rate is 15.3% on 92.35% of net earnings from self-employment.
• Self-employed individuals generally pay this tax through quarterly taxes to the Internal Revenue Service (IRS).
• A portion of the self-employment tax is deductible when calculating adjusted gross income for income tax purposes.
• This tax ensures self-employed individuals qualify for Social Security and Medicare benefits, crucial for future retirement planning.

Formula and Calculation

The self-employment tax is calculated on your net earnings from self-employment. The general formula involves taking your gross income from your trade or business and subtracting all ordinary and necessary business expenses to arrive at your net profit.²³

The amount subject to self-employment tax is 92.35% of your net earnings from self-employment.²²,²¹ The tax rate is 15.3%, which comprises 12.4% for Social Security and 2.9% for Medicare.²⁰ There is an annual earnings limit for the Social Security portion, but not for the Medicare portion.¹⁹

The formula to calculate the self-employment tax (SE Tax) is:

Where:

• Net Earnings from Self-Employment is your gross income less all allowable deductions and depreciation from your trade or business.¹⁸
• 0.9235 represents 92.35%, the portion of your net earnings subject to self-employment tax.
• 0.153 represents 15.3%, the combined Social Security (12.4%) and Medicare (2.9%) tax rate.

Interpreting the Self-Employment Tax

Understanding self-employment tax is critical for individuals who are self-employed. The tax rate of 15.3% might appear higher than the Social Security and Medicare taxes withheld from an employee's paycheck, but it is effectively equivalent to the combined employee and employer portions of those taxes. Employees only see their 7.65% share deducted, while their employer pays the other 7.65%. Self-employed individuals are responsible for both shares.¹⁷

A key interpretation is that this tax is separate from federal income tax. While both are reported on the same tax return, the self-employment tax is specifically for Social Security and Medicare contributions. Properly accounting for this tax is crucial to avoid underpayment penalties and to ensure proper credit for future benefits.

Hypothetical Example

Consider Alex, a freelance graphic designer operating as a sole proprietor. In a given year, Alex earns $60,000 in gross income from design projects. Alex incurs $10,000 in ordinary and necessary business expenses, such as software subscriptions, office supplies, and marketing costs.

1. Calculate Net Earnings from Self-Employment:
   Gross Income: $60,000
   Business Expenses: $10,000
   Net Earnings: $60,000 - $10,000 = $50,000

2. Calculate Amount Subject to SE Tax:
   $50,000 (Net Earnings) \times 0.9235 = $46,175

3. Calculate Self-Employment Tax:
   $46,175 \times 0.153 = $7,069.98

Therefore, Alex's self-employment tax for the year would be approximately $7,070.

Additionally, Alex can deduct one-half of this self-employment tax ($7,069.98 / 2 = $3,534.99) when calculating their adjusted gross income for income tax purposes, thereby reducing their overall tax liability. This deduction is independent of whether Alex itemizes deductions.¹⁶,¹⁵

Practical Applications

Self-employment tax has several practical applications for individuals working outside of traditional employment:

• Tax Compliance: It mandates that gig economy workers, freelancers, and small business owners fulfill their obligations for Social Security and Medicare. These individuals are generally required to estimate their annual tax liability and make regular quarterly taxes payments to the IRS to cover both income tax and self-employment tax.¹⁴,¹³
• Benefit Eligibility: Paying self-employment tax contributes to an individual's earnings record with the Social Security Administration (SSA). This record determines eligibility and the amount of future Social Security retirement, disability, and survivor benefits, as well as Medicare coverage.¹²
• Financial Planning: Understanding this tax allows self-employed individuals to budget accurately and manage their finances more effectively. Neglecting to account for self-employment tax can lead to unexpected tax bills and potential penalties. The IRS provides resources and forms, such as Form 1040-ES, to help individuals calculate and pay estimated taxes.¹¹,¹⁰

Limitations and Criticisms

While the self-employment tax is a fundamental component of the U.S. tax system for self-employed individuals, it also faces certain limitations and critiques:

• Complexity for New Self-Employed: First-time self-employed individuals often find the calculation and quarterly payment requirements confusing, potentially leading to underpayment penalties.⁹ Unlike traditional employment where taxes are withheld automatically, self-employed individuals must proactively manage their tax obligations.
• Cash Flow Management: For small businesses or individuals with fluctuating income, accurately estimating and setting aside funds for quarterly payments can be challenging, impacting cash flow. This can be particularly burdensome during periods of low earnings.
• Perceived Double Burden: Although mathematically equivalent to combined employee/employer contributions, the psychological effect of paying both halves of the tax can feel like a heavier tax burden compared to employed individuals who only see their employee portion deducted.

Self-Employment Tax vs. Payroll Tax

Self-employment tax and payroll tax both fund Social Security and Medicare, but they apply to different employment structures and have distinct administration. Payroll tax, also known as Federal Insurance Contributions Act (FICA) tax, is levied on wages and is split between employees and employers. Employers withhold the employee's portion (7.65%) from their paychecks and pay their own matching portion (7.65%) directly to the government.

In contrast, self-employment tax (Self-Employment Contributions Act or SECA tax) is paid by individuals who work for themselves, such as sole proprietors, partners, or independent contractors. These individuals are responsible for paying both the employee and employer portions, totaling 15.3% on a portion of their net earnings. The key difference lies in the responsibility for payment and administration: an employer handles payroll taxes for their employees, while self-employed individuals manage and pay their self-employment taxes directly.

FAQs

Who must pay self-employment tax?

You generally must pay self-employment tax if your net earnings from self-employment were $400 or more during the tax year. This applies to freelancers, independent contractors, and small business owners.⁸

How do I pay self-employment tax?

Self-employment tax is typically paid through estimated tax payments made quarterly to the IRS, using Form 1040-ES. You can pay online, by phone, or by mail.⁷,⁶

Is self-employment tax deductible?

Yes, you can deduct one-half of your self-employment tax when calculating your adjusted gross income for income tax purposes. This deduction reduces your overall tax liability.⁵,⁴

What happens if I don't pay enough self-employment tax?

If you don't pay enough tax through your estimated payments, you may face penalties for underpayment. It's crucial to accurately estimate your income and pay your tax credit installments on time to avoid such penalties.³,²

Does self-employment tax count towards Social Security benefits?

Yes, the self-employment tax contributions are credited to your Social Security earnings record, determining your eligibility for future social security retirement, disability, and survivor benefits, as well as Medicare coverage.¹