Self-Employment Tax - Explained
What are Self-Employment Taxes?
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Table of ContentsWhat is Self-Employment Tax?How Does Self-Employment Tax Work?How to Pay Self-Employment TaxAcademic Research on Self Employment Tax
What is Self-Employment Tax?
Self-employment tax is a type of tax payable by individuals such as small business owners who work for themselves. It consists of Social Security and Medicare taxes that the federal government deducts from income of such individuals. Any self-employed individual with a net income of $400 or more per tax year is liable to pay a self-employment tax. Information regarding self-employment tax is available on Schedule SE (Form 1040) of the Internal Revenue Service (IRS).
How Does Self-Employment Tax Work?
Before we go on to describe self-employment tax, it is important to define the term self-employed. Any individual can be considered to be self-employed if he works for himself. As such freelancers, sole proprietors and independent contractors, consultants, coaches and trainers can all be considered to be self-employed. The federal government regulations mandate that all such individuals with an annual income of $400 or more are liable to pay a self-employment tax at the rate of 15.3%. The breakup of this tax rate is as follows:
- 12.4% will be collected for social security (old-age, survivors, and disability insurance).
- 2.9% will be collected for Medicare (hospital insurance).
An important point to note here is that any employee who is not self-employed is only required to contribute 6.2% towards social security, while another 6.2% is deducted on his behalf from his employer. However, since a self-employed individual can be considered as both the employer as well as the employee, he is liable to pay both portions of social security (i.e. 6.2% + 6.2% = 12.4%). However, there exists only a single tax bracket for social security tax and that is the first $128,400 of self-employment income earned. Also, the maximum social security tax that can be collected per individual has been set at $15,921.60 for the year 2018. In the event that the annual income of a self-employed individual is subject to either a social security tax or the Tier 1 segment of the railroad retirement tax, or both, he is not required to pay the 12.4% social security part of the self-employment tax on any of his net earnings. Additionally, although the Medicare tax has been fixed at 2.9%, any individual with an annual income over $200,000 has to pay an additional 0.9% Medicare tax. In case of married couples filing jointly, the tax bracket has been relaxed to $250,000. It is important to comprehend, at this juncture, that self-employment tax is considered a tax-deductible expense that is chargeable on the individuals net income from business. The IRS does offer such a taxpayer the option to consider the employer half of the self-employment tax, or 7.65% (which is half of the total SE tax of 15.3%) as a business deduction in order to determine the total tax due. As such, self-employment tax is typically calculated on 92.35% of the net income (100% - 7.65% = 92.35%). Unlike regular employees who are subject to their employers withholding 7.65% from their paychecks, self-employed individuals are not required to withhold tax. However, such taxpayers are still required to make estimated tax payments on a quarterly basis in order to fulfill their self-employment tax obligations.
How to Pay Self-Employment Tax
Any self-employed individual who has either a Social Security number (SSN) or an individual taxpayer identification number (ITIN) can pay a self-employment tax. All information pertaining to self-employment tax is available on Schedule SE (Form 1040) of the IRS. Form 1040-ES contains details to calculate and pay estimated taxes. As of 2019, a self-employed individual must pay an estimated tax if he is subject to the following conditions:
- The individual is expected to owe at least $1,000 in tax for the year, after subtracting his withholding and refundable credits.
- The individual estimates his withholding and refundable credits to be less than the lesser of:
- 90% of the tax to be shown on the tax return for the tax year.
- 100% of the tax shown on the previous years tax return, given that the tax return for the previous year covers all 12 months.
It should be noted that the percentages cited above might differ for farmers, fishermen and taxpayers with higher incomes.