If you’re like many Americans, you cringe when you hear the word “tax”. Unfortunately, no matter how much you can’t stand the thought of paying Uncle Sam a portion of your income, it’s a part of working in the American economy. If you’re someone who works for yourself, you must also pay something called the self-employment tax.
But, what is the self employment tax? And, how does it impact your pay?
What is Self-Employment Tax and Why Does it Matter?
When you’re employed, you must pay social security and Medicare tax as part of payroll taxes. The contributions you make to each go toward the funding of your Social Security coverage, which is a social insurance program that provides retirement, disability, and survivor benefits for those who qualify. Meanwhile, Medicare provides health insurance to those 65 and older, and some younger people with disabilities. In short, these programs are a safety net for you when you can no longer work.
The Social Security payments you'll receive will be based on the number of years you worked and how much you paid into the fund.
As an employee, your employer will split the social security and Medicare tax with you. For 2021, you and your employer will each pay 6.2 percent for the social security tax and 1.45 percent for the Medicare tax via FICA payroll tax withholding.
But, when you're self-employed, you must pay the employee and employer portion. So, instead of paying a total of (6.2 percent + 1.45 percent), which equals 7.65 percent, you’ll pay the full 15.3 percent.
You're considered self-employed for tax purposes if you're a sole proprietor, an independent contractor such as a freelancer, or other small business or LLC owner.
Who Must Pay Self-Employment Tax?
In general, self-employed people just must pay the self-employment tax as long as they make $400 or more in self-employment gross earnings or receive $108.28 or more of income as a church employee.
According to the IRS, you’re self-employed if one of the following applies to your situation:
- You conduct business or perform a particular trade as an independent contractor or as the sole proprietor of your own business.
- You’re a member of a business partnership.
- You have your own business through some other means, including running a business part-time, like a side hustle.
This criteria applies to pretty much everyone, even if you’re a minor or already receiving Social Security benefits.
What is the Self-Employment Tax Rate for 2019 (2020 and 2021)?
For the years 2019, 2020, and 2021, the self-employment tax rate is 15.3 percent —12.4 percent for social security and 2.9 percent for Medicare. However, there are a few details worth pointing out, including:
- For 2019, you must pay the social security tax on your first $132,900 of business income generated.
- For 2020, you must pay the social security tax on your first $137,700 of business income generated.
- For 2021, you must pay the social security tax on your first $142,800 of business income generated.
- For 2022, you must pay social security tax on your first $160,000
- If your net income is over $200,000 as a single filer or $250,000 as a joint filer, you must pay a 0.9 percent additional Medicare tax.
There’s no cap for Medicare contributions, so you’ll always be paying that 2.9 percent tax (or more if you meet certain income thresholds, which we discuss below).
How is Self-Employment Tax Calculated?
You can calculate your self-employment tax by using the following steps.
- Figure out how much in self-employment earnings you made within a year. You'll want to use your net earnings, which is usually the total amount you made (adjusted gross income) minus any qualifying business expenses such as money spent on marketing.
- Calculate 12.4 percent of your net earnings for your social security tax contributions. Keep in mind; you only need to apply the 12.4 percent to earnings up to $142,800.
- Calculate 2.9 percent of all your net earnings for your Medicare tax.
- And…finally calculate an additional .9 percent on earnings over $200,000 as a single filer or $250,000 as a joint filer for your additional Medicare tax. Add this amount to your final.
Let's go over a quick example. Say Mary has made $230,000 this year as a freelance architect.
- Her net earnings = $230,000
- Her social security tax contributions = 12.4 percent x $230,000 = $28,520
- Her Medicare tax contributions = 2.9 percent x $230,000 = $6,670
- Additional Medicare tax contributions on earnings over $200,000 (i.e. on $30,000) = .9 percent x $30,000 = $270
Mary's grand total for self-employment taxes is $35,460.
Remember, if you made less than $400 in self-employment income, you might not have to pay the self-employment tax at all. If you earn an income from an employer and receive self-employment income, you’ll pay the self-employment tax only on the self-employment income and FICA tax on the employee income portion.
Self-Employment Tax Estimates
When you're an employee, your employer withholds part of your paycheck for social security, Medicare, and income taxes to send to the government. But, when you're self-employed, the responsibility of withholding taxes falls on you.
To ensure Uncle Sam is getting his fair share through the year, the government wants you to make tax estimate payments. If you don't pay at least 90 percent of the current year, it's possible you may have to pay the penalty for underpayment. So, how much of a penalty are we talking about?
The IRS calculates your underpayment penalty by:
- Determining how much tax you paid each quarter
- Applying a penalty rate to each quarter of underpayment
- Adding up penalties for each quarter
Keep in mind, your state may also require estimates.
You can estimate these payments by using tax form 1040-ES and make them online through the IRS's EFTPS (Electronic Federal Tax Payment System) following the IRS's estimated tax payment schedule.
Federal estimates are based on when you received the self-employment income. Here are the tax payment due dates:
- Income generated between January 1, and March 31 are due April 15
- Income generated between April 1 and May 31 are due June 15
- Income generated between June 1, and August 31 are due September 15
- Income generated between September 1, and December 31 are due January 15 of the following year
Likely, your state and local municipalities will require income tax estimates and have underpayment penalties as well. For example, if you underpay your taxes in Michigan, you must pay a 25 percent penalty for failing to file estimated tax payments or 10 percent of underpaid tax per quarter.
Again, check with your state's tax agency and local municipalities for details about rates and deadlines.
Payroll for the Self-Employed
Because self-employed individuals don’t have a payroll through an employer (of sorts), sole proprietors can imitate payroll by putting their business’s profits into a separate bank account. Then the owner can withdraw quarterly estimates throughout the year.
As you expand your business, you may want to form a legal business entity, like an LLC (Limited Liability Company) or an S-Corporation. Then, you’ll be able to hire employees and pay them via payroll.
Additionally, you’ll want to think about payroll services like Hourly, which automatically calculates your payroll taxes for you, and pays them.
How Do I Report Self-Employment Income to the Social Security Administration and the IRS?
If you earn self-employment income, you must report it to the IRS (Internal Revenue Services) by the year's tax filing deadline. Usually, the tax filing deadline is April 15th.
To differentiate your self-employment tax from federal income tax, the IRS requires multiple forms, including:
- File Form 1040 (U.S. Individual Income Tax Return)
- File Schedule SE (Self-Employment Tax)
- File Schedule C (Profit or Loss from Business) or Schedule F (Profit or Loss from Farming) as appropriate
You can access all the forms you need from the IRS website, using tax filing software, or partnering with a tax professional. You'll need to submit all forms even if you don't owe income taxes or self-employment tax.
The IRS then reports all of your income data to the Social Security Administration (SSA), which administers all Social Security benefits.
How Much Tax Do You Pay If You Are Self-Employed?
Ready for some good news? Despite paying an extra tax as a self-employed individual, the IRS gives you some breaks (thank goodness).
For starters, the IRS allows you to cut your federal self-employment tax by half before applying the actual tax rate. So, let’s say your net earnings of self-employment income was $50,000. If you were taxed on the full amount your self-employment tax would be $7,650 ($50,000 x 15.3 percent = $7,650). But, since you can cut it in half, your self-employment tax is now $3,825 ($7,650/2).
You can subtract this amount from your net earnings. So now your net earnings are $46,175, and your taxes are 15.3 percent x $46,175, which equals $7,064, a savings of $585.
Business Tax Deduction
Want even more good news? Half of your self-employment tax is deductible from income taxes, as a taxpayer. So, if your schedule SE states you owe $1,000 for the entire tax year, you can deduct $500 on your 1040 form when tax time comes around.
But, calculating the self-employment tax can be complicated for business owners and self-employed individuals. So, partnering with a tax professional might be a good solution for ensuring you receive all the tax deductions you’re entitled to.
Why Do I Have to Pay Self-Employment Tax?
Like income and sales taxes, taxes are just a way of life. But, unfortunately, while business owners and other independent workers have the flexibility to work for themselves, they also have a more substantial tax liability since they must pay the same amount in taxes as everyone else.
Look at it this way, the purpose of the self-employment tax is to fund Social Security and Medicare for your benefit. Therefore, even if you never save for your retirement, you're able to receive Social Security retirement benefits, which can provide financial support in your golden years. Also, your additional Medicare tax contribution will help you pay for your medical and health care expenses in the future.
So, while it may seem like a pain now, you'll be grateful when you're about to retire, and you have an extra income stream.
Can You Collect Social Security If You Are Self Employed?
Yes, you can collect Social Security if you’re self-employed, as long as you pay into the program for a certain amount of time.
The SSA determines the amount of Social Security benefits you receive by adding up your credits. The amount you make, the number of years of work, and your date of birth go into calculating your total credit amount. However, you don’t need to work more than ten years (earning 40 credits) to receive benefits.
In 2021, if you make $5,880 or more, you will earn four credits, which is the maximum amount you can earn in one year. In other words, you receive one credit for each $1,470 of earnings during the year. Even if you make less than $5,880 during the year, you may still earn credits based on your total amount.
To determine your eligibility for Social Security, you can visit SSA.gov. Also, since the SSA monitors your annual gross earnings, you can check out your credits by creating a “my Social Security Account.”
What Income Reduces Social Security Benefits?
Remember, even those who are receiving Social Security benefits are taxed if they receive self-employment income. So, once you begin receiving Social Security benefits, there are limits on the amount of money you can earn without impacting your benefits.
If you’re under full retirement age, you can earn up to $18,960 without reducing your benefits. If you earn more than that, the SSA reduces $1 for every $2 you make over the limit.
The limit increases to $50,520, if you will reach full retirement age in 2021. If you earn more than that, the SSA reduces your benefit by $1 for every $3 you make over the limit.
To determine your full retirement age, the SSA has a full retirement age chart.
How Self-Employment Affects Social Security Benefits
Social Security credits work the same way for those who are employed and those who are self-employed. You can qualify and earn them the same way. However, the thing that sets them apart is the business tax deductions you claim on Schedule C.
Since these business tax deductions lower your taxes, they can also lower your potential Social Security benefits when you retire.
Putting it Altogether: Self-Employment Tax
As a sole proprietor or independent contractor, it’s up to you to manage your taxes. Since your taxes aren’t withheld the way they are when you work for someone else, you may need to pay yourself a salary.
Ensuring you have a strategy in place to pay your self-employment tax will ensure Uncle Sam doesn’t come knocking on your door.