What Is Self Employment Tax, and How Do You Calculate It? 

what is self employment tax
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You may have observed as an employee that your paycheck never equals your complete wage. This is due to the fact that your company is required to withhold some payroll taxes. You may believe that if you work for yourself, you are exempt from paying payroll taxes. Nonetheless, you would still be subject to a 15.3% self-employment tax. Here, we’ll explain how the self-employment tax works and how to calculate it, including the jobs that are exempt from paying this tax. 

What Is a Self-Employment Tax?

The term self-employment tax refers to the federal government’s collection of taxes from self-employed individuals and small business owners to fund Medicare and Social Security. The self-employment tax is similar to the employer-paid Federal Insurance Contributions Act (FICA). This tax is levied when an individual earns $400 or more in self-employment income during the tax year or $108.28 or more from a tax-exempt church. IRS Form 1040 Schedule SE is used to calculate and report the tax. Persons who earn less than these criteria from self-employment are exempt from paying taxes.

How The Self-Employment Tax Works

The self-employment tax is intended to be collected from self-employed workers who do not otherwise pay withholding taxes. Sole proprietors, freelancers, and independent contractors who operate a trade or business are included. The Internal Revenue Service may regard a member of a partnership that operates a trade or business to be self-employed (IRS). Self-employed people must pay self-employment tax in order to get Social Security benefits when they retire.

Both the corporation and the employee are taxed in any business to pay for the two major social welfare programs: Medicare and Social Security. Individuals who are self-employed are considered both the corporation and the employee in the eyes of the IRS, therefore they must pay both portions of this tax.

How The Self Employment Tax Is Levied

The Social Security tax is levied at a rate of 6.2% on employers and 6.2% on employees. As a result, a self-employed worker is taxed at 12.4% (6.2% + 6.2%) because they are both an employer and an employee. The Social Security tax is only levied on the first $147,000 in self-employment income, with a maximum levy of $18,228 in 2022. This amount rises in 2023 and applies exclusively to the first $160,200 of income, for a total tax of $19,864.80.

The Medicare tax is levied at a rate of 1.45% for employers and 1.45% for employees. As a result, a self-employed worker is taxed at a rate of 2.9% (1.45% + 1.45%) because they are both an employer and an employee. 7 Medicare taxes have no income limit. The combined self-employment tax rate is 15.3% (12.4% + 2.9%). In 2022, a self-employed person with a total net income of $137,700 would owe $21,068.10 in taxes ($137,700 x 15.3%).

Self-employment taxes are tax deductible. While the tax is levied on a taxpayer’s company profit, the IRS allows the employer to deduct half of the self-employment tax, or 7.65% (calculated as half of 15.3%), as a business deduction when calculating that taxpayer’s income tax.

Self-Employment Tax Illustration 

Individuals typically pay self-employment tax on 92.35% of their net earnings, not 100% of their total earnings, contrary to popular belief.

This is how it works.

If a person owns a human resource (HR) consulting firm and estimates their total net income for 2022 to be $200,000 after deducting business expenses. Their self-employment tax will be calculated at 92.35% of $200,000, for a total of $184,700. This amount exceeds the Social Security part of the self-employment tax limitation. As a result, Robin’s self-employment tax liability will be $23,063.50. This value is calculated as ($142,800 x 12.4%) + ($184,700 x 2.9%)

$17,707.20 + $5,356.30

They can claim an above-the-line deduction for half of their self-employment tax, or $23,063.50 2 = $11,531.75, when they file their 2022 income tax return. In effect, they receive a deduction for the employer share of their self-employment tax (6.2% Social Security + 1.45% Medicare = 7.65%).

How to Calculate Self-Employment Tax

Determining your tax begins with computing your net self-employment earnings for the year.

Net earnings are typically your gross income from self-employment less your business expenses for tax purposes.

Self-employment tax is generally levied on 92.35% of your net profits from self-employment. Apply the 15.3% tax rate once you’ve calculated how much of your net profits from self-employment are taxable. But keep in mind that only the first $147,000 ($160,200 in 2023) of earnings is liable to the Social Security share of self-employment tax in 2022.

Who Is Required To Pay Self Employment Tax?

In general, you must pay self-employment tax if one of the following occurs during the year:

  • You earned at least $400 in net profits from self-employment (excluding anything you made as a church employee). If you received a 1099 form from a company for which you did work, you may be considered self-employed by the IRS.
  • You earned at least $108.28 every week from religious work.
  • The tax laws apply regardless of your age or whether you receive Social Security or Medicare.

What Kinds Of Jobs Are Exempt From Paying The Self Employment Tax?

Any job with a yearly salary of less than $400 is excluded. This holds true regardless of the type of labor performed. A significant exception pertains to clergy employed by a congregation. Their whole earnings are exempt from self-employment taxation. The exemption may not apply if a clergy member is compensated through a church organization rather than directly by the congregation.

How to Pay Self-Employed Income Tax

  • To compute your net earnings from self-employment, generally use IRS Schedule C.
  • To figure out how much self-employment tax you owe, utilize IRS Schedule SE.
  • When you pay the tax, you must submit your Social Security number or individual taxpayer identification number (ITIN).

In the United States, taxes are paid as you go, so waiting until the annual tax-filing date to pay your self-employment tax may result in late-payment penalties. If you expect to:

  • Even with withholding and refundable credits (such as the earned income tax credit), you’ll owe at least $1,000 in federal income taxes this year.
  • Your withholding and refundable credits will cover less than 90% of your tax burden for the year, or 100% of your liability from the previous year, whichever is less. (If your adjusted gross income was more than $150,000 for married couples filing jointly or $75,000 for singles, the threshold is 110% of the tax owed the previous year.)

Self Employment Tax Breaks

On your income taxes, you can deduct half of your self-employment tax. For example, if your Schedule SE shows that you owe $2,000 in self-employment tax for the year, you must pay that amount when it is due, but $1,000 is deducted on your 1040 at tax time.

Self-employment can also get you a slew of tax breaks. One is the qualifying business income deduction, which allows you to deduct up to 20% of your self-employment net income from your income taxes. There are also deductions for your home office, health insurance, and other expenses.

How to File Self-Employed Income Taxes

#1. Check to see if you actually have to pay.

Not everyone is subject to self-employment tax, but if you are, you will almost certainly have to pay it if you’re among the following:

  • Sole proprietorship.
  • Self-employed individual
  • A proprietor of a small business
  • A contract worker
  • A side hustler — even if you also have a W-2 job.

To summarize, self-employment taxes are levied on all “earned income,” which is money received in exchange for a product or service. That is true whether it is your primary source of income or not.

Assume you work a conventional 9-to-5 job but sell your handcrafted jewelry on Etsy to supplement your income. Self-employment tax applies to your sales!

#2. Determine your earnings.

This is the starting point for all taxes: you must know how much money you got before anything else is meaningful. If you don’t keep solid records, the year-end tax forms you receive will be crucial.

If you earned more than $600 from a single customer or work platform, you will almost certainly receive a 1099-NEC by January 31st. You may also receive a 1099-K for payments made through a third-party payment processor such as PayPal or Stripe.

You can use these statements to calculate your annual income. I also strongly advise going through your bank statements for any revenue that may have been overlooked or falls below the $600 reporting requirement.

#3. Compile your business costs.

If you’re already looking through your bank statements, scan for business-related spending while you’re at it. Don’t forget to double-check your credit card purchases!

Typical business expenses for self-employed individuals

Common company expenses include: your phone bill; office supplies; computers and software; continuing education; automobile expenses; and marketing and advertising.

Once you’ve determined your annual business expenses, subtract them from your gross income to see how much you’ll be taxed on.

#4. Determine how much you owe.

You merely need to find out how much to pay now. If this is your first year working for yourself, expect a substantially bigger tax bill than usual due to the 15.3% self-employment tax.

Paying self-employment tax isn’t the only thing that makes tax season difficult for freelancers. One advantage of W-2 work is that there are fewer surprises when it comes time to pay.

Income and FICA taxes are withheld automatically by the employer and sent to the IRS at the time they are owed. Self-employed individuals, on the other hand, have a more difficult time automating their tax bill.

Figuring out your freelance tax bill

To calculate your SE tax, you must first determine your net income. This is your profit after deducting business expenses.

Assume you produce $10,000 in gross income and have $5,000 in company expenses. Your take-home pay would be $5,000. You’ll have to pay SE tax on this $5,000, not the entire $10,000. Hence your SE tax would be $765 ($5,000 multiplied by 15.3%).

#5. Choose your pay schedule.

Many individuals are unaware that taxes are not officially due on April 15th. They are due when the money is earned. This is why employers remit payroll taxes all year.

Of course, freelancers and independent contractors do not have employers who will do this for them. As a result, many of them must pay their taxes quarterly in the form of “estimated tax payments.” These payments are due by the 15th business day of the month after a quarter’s end:

The first quarter (January-March) is due. The 15th of April

The second quarter (April-June) is due. The 15th of July

The third quarter (July-September) is due. The 15th of October

The fourth quarter (October-December) is due. 15th January

Anybody who anticipates to owe the IRS more than $1,000 must make quarterly payments or face underpayment penalties.

#6. Determine whether you are needed to file.

Taxpayers with solely W-2 income do not have to file a tax return if their earnings for the year were less than the standard deduction ($12,400 in 2021).

Those who work for themselves, on the other hand, receive the short end of the stick. If your net earnings are $400 or more, you must file a tax return.

The IRS does this to collect self-employment taxes. If your earnings are that low, you won’t have to pay income tax, but you may have to pay self-employment tax.

#7. Complete your tax forms

If you do your own taxes, you’ll have to deal with the following forms on your annual return:

Form 1040

Most of you should be familiar with this. Individual taxpayers use Form 1040 to report all of their taxable income and calculate their taxes.

C Schedule

This form is intended for sole owners and other self-employed individuals. This is where you will disclose your gross business income and costs.

Line 31 of Schedule C crosses over to Schedule 1 of the 1040 and Schedule SE to compute the taxes you owe.

When you submit your federal taxes, your Schedule C will be linked to your Form 1040.

When you complete Schedule C, you’ll notice that it includes various types of company expenses. Several of these are simple to grasp, while others might be perplexing.

Price of Items Sold

This category is used to record inventory prices. It encompasses both tangible and virtual goods. For example, if you sell online advertising, you could include the cost of getting digital ad space here.

If you intend to use this line, make sure to fill out the Cost of Products Sold section on page 2 of Schedule C.

Vehicle expenses

If you are claiming auto expenditures, you must complete part IV of Schedule C on page 2 before entering the total on line 9 of page 1.

Depreciation costs

This is the section where you record the total depreciation on all of your fixed assets for the year.

To use this category, you must complete Form 4562, which details all of your fixed assets (such as machinery, equipment, and automobiles), as well as their basis and depreciation methods.

Deduction for home office

If you want to itemize your home office deduction rather than claiming the simplified amount, you must fill out Form 8829 and attach it to your return.

The sum on Form 8829 will be carried over to line 30 of Schedule C.

SE Schedule

Your self-employment taxes are calculated using Schedule SE. You’ll complete this together with Schedule C and attach it to your 1040 when you file.

In Conclusion,

The self-employment tax ensures that self-employed people contribute the same amount and enjoy the same advantages as salaried workers. The 15.3% figure may surprise newly self-employed people. But, when all is said and done, tax deductions can save you from paying the full amount of tax.

Don’t forget that if you don’t have an employer, you’ll have to do a lot of the tax math yourself. If you are overwhelmed or perplexed by the paperwork and rules, you may benefit from professional tax assistance.

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