The Self-Employment Tax, Explained by a Self-Employed CPASmall Business Taxes
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If you recently started a business, you’ve undoubtedly heard of the self-employment tax.
And you’re probably asking yourself questions like:
- What is the self-employment tax?
- Will I have to pay the self-employment tax?
- How can I avoid the self-employment tax or at least reduce the amount I have to pay?
In this article, I’ll tell you everything I’ve learned about the self-employment tax as a CPA who is self-employed himself.
And not only that, but at the end of the article, I’ll share with you some tips and tricks on how you can reduce your self-employment tax liability.
But first, let’s start with the basics.
What Is the Self-Employment Tax?
The self-employment tax is a self-employed person’s Social Security tax liability and Medicare tax liability.
Not sure what those taxes are? Let me explain.
Social Security Tax and Medicare Tax
With some exceptions, all taxpayers with earned income — whether paid as salary or wages from a job or as self-employment income from a business — have to fund the Social Security and Medicare programs with a portion of their earnings.
Jointly, these Social Security and Medicare contributions are referred to as the FICA tax.
FICA stands for the Federal Insurance Contributions Act, which is the piece of legislation passed in 1935 mandating the tax.
FICA Tax Rates
Currently, the Social Security tax rate is 12.4%, and the Medicare tax rate is 2.9%, for a total of 15.3%.
But there’s a limit on how much in earnings is subject to the Social Security tax; in 2020, this limit is $137,700 (it was $132,900 in 2019), and it gets adjusted for inflation every year. So if you make $200,000 in 2020, only $137,700 will be subject to the Social Security tax.
There is no such limit on the Medicare tax; if you make $200,000 in 2020, all of it will be subject to the Medicare tax.
Employees Only Pay 50% of Their Own FICA Tax
If you have a W-2 job working for someone else, you’ll likely see on your paycheck deductions for various taxes.
One of these line items taken out of your paycheck is for Social Security, and another is for Medicare.
But here’s the thing: employees only pay for half of their own FICA tax.
That’s right! Rather than the full 12.4% for Social Security tax (up to $137,700 in 2020) and the full 2.9% for Medicare tax, employees only pay 6.2% and 1.45% respectively (for a total of 7.65%).
The employer pays the remaining 7.65% on the employee’s behalf.
But Self-Employed People Have to Pay 100% of Their Own FICA Tax
Self-employed people, on the other hand, work for themselves.
They don’t have a boss to cover half of their FICA tax for them; they have to pay it all themselves, at least since the Self-Employment Contributions Act (SECA) was passed in 1954!
So this is what self-employment tax is: the FICA tax (or more specifically, the SECA tax) assessed on self-employment earnings at a rate of roughly 15.3% (12.4% for Social Security tax and 2.9% for Medicare tax).
I say “roughly” because only the first $137,700 of earnings (in 2020) is subject to the Social Security tax and because the self-employment tax is actually only assessed on 92.35% of your self-employment income (more elaboration on that later).
Who Must Pay the Self-Employment Tax?
Individual taxpayers with $400 or more of self-employment income must pay the self-employment tax.
What Is Self-Employment Income?
Self-employment income is the net income you earn in carrying on a “trade or business” as a sole proprietor or partner in a partnership.
Examples of self-employment income include everything from driving for Uber or Lyft to selling cookies at your own bakery to providing high-end consulting services.
If you perform work for someone who is not your employer, you are considered to be an independent contractor, and any money you receive in this capacity in considered self-employment income.
If someone paid $600 or more to you as an independent contractor during the year, they will issue you a Form 1099-MISC indicating the amount you were paid in Box 7 as “Nonemployee Compensation”.
However, even if you do not receive a 1099-MISC for money you were paid, you are still obligated to report the income you earned on your return as self-employment income.
Self-Employment Tax Deductions
In the previous section, I told you that self-employment income is the net income you earn in a trade or business.
“Net” means “after-deductions.”
Yes, there are plenty of deductions you can take in calculating your self-employment income!
Here are a few of them:
- Accounting fees
- Legal fees
- Travel expenses
- Vehicle expenses such as mileage
So if you grossed $150,000 in your business last year, but you had $50,000 of deductions, your net self-employment income would be $100,000.
How Much Is the Self-Employment Tax?
So like I said, once you hit $400 or more in self-employment income during the year, you’re on the hook for the self-employment tax.
But how do you calculate it?
Well, the short, sweet, and slightly inaccurate answer is that the self-employment tax is 15.3% of your net self-employment income.
But the actual self-employment tax calculation is a bit more complicated than that, and below I walk you through exactly how to calculate the self-employment tax.
Step 1: Multiply Your Self-Employment Income by 92.35%
This step sounds completely random, right?
Like, why the heck do you multiply your self-employment income by 92.35% to calculate the self-employment tax?
Well, let’s start with this: 100.00% – 92.35% = 7.65%.
Sound familiar? Yup, that’s half of the FICA tax rate (see under “Employees Only Pay 50% of Their Own FICA Tax” above).
See, when employers pay half of their employees’ FICA tax, they get to deduct that amount as payroll tax expense.
So the logic here is that you should be getting a “deduction” for self-employment tax purposes equal to half of the self-employment tax that you, as your own employer, are paying on your own behalf, and this “deduction” amounts to 7.65% of your self-employment income, leaving only 92.35% of your self-employment income subject to the self-employment tax.
To keep the example easy, let’s assume that you netted $100,000 in your business last year.
Multiplying $100,000 by 92.35%, we get $92,350. This is the amount of your self-employment income subject to the self-employment tax.
Step 2: Calculate Your Medicare Tax Liability
This step is easy: multiply the number you came up with in Step 1 by the Medicare tax rate of 2.9%.
In our example, this number is $2,678 = $92,350 x 2.9%.
This is the Medicare tax component of the self-employment tax.
Step 3: Calculate Your Social Security Tax Liability
This step is a bit trickier than Step 2 because as we mentioned, there is a statutory limit on the total amount of earnings subject to the Social Security tax.
As stated previously, in 2020, this limit is $137,700.
It’s important to note that this limit is on a per-person basis, even for taxpayers filing jointly with their spouse. For example, the fact that your spouse makes, say, $150,000 in 2020 and therefore maxes out his or her own Social Security wage base has nothing to do with your Social Security tax calculation.
Scenario 1: Earnings at or Below $137,700
Let’s start with the easy scenario where you don’t have to worry about that $137,700 limit on earnings subject to the Social Security tax.
In fact, let’s continue our example by adding the fact that you did not have any other income than the $100,000 we have been discussing.
In this case, because $92,350 is the amount subject to self-employment tax, you simply multiply $92,350 by the Social Security tax rate of 12.4% to calculate your Social Security tax liability.
In this scenario, this amount is $11,451 = $92,350 x 12.4%.
Scenario 2: Earnings Over $137,700
So let’s continue our example but throw in this little wrench: you also have a day job that pays $50,000, and between you and your employer, FICA taxes have already been paid in full on this amount.
If we add your earnings subject to self-employment tax of $92,350 to this $50,000, we get $142,350.
Because this amount is greater than the statutory limit for 2020 of $137,700, we must only consider for Social Security tax purposes the amount of your earnings subject to self-employment tax that is equal to $137,700 less the $50,000 in already-taxed wages.
$137,700 – $50,000 = $87,700. This is the amount that you multiply by 12.4%, yielding $10,875 in Social Security tax liability on your self-employment income.
Step 4: Add Your Medicare Tax Liability and Social Security Tax Liability
In this step, you simply add the amounts you came up with in Step 2 and Step 3.
Under the scenario where you do not have a day job, your total self-employment tax would be $2,678 + $11,451 = $14,129.
Under the scenario where you have a day job earning $50,000, your total self-employment tax would be $2,678 + $10,168 = $12,846.
Congratulations: you now know how to calculate the self-employment tax.
But wait, there’s more!
Step 5: Calculate the Deduction for One-Half of Self-Employment Tax
Just like employers get to take a deduction for the FICA tax they pay for their employees, you too get to take a deduction for one-half of the FICA tax, that is, the self-employment tax, you pay on behalf of yourself. (And again, if we’re really splitting hairs here, we would probably call it the SECA tax, but the numbers are the same.)
This deduction is taken on the Form 1040 itself.
To calculate this deduction, you simply multiply your self-employment tax amount by 50% and report it directly on Line 26 of Schedule 1, which gets attached to your Form 1040.
How to File Self-Employment Taxes
You report your self-employment tax using Schedule SE, which is attached to your Form 1040 when you file it.
Sounds simple enough, right? Just another form that basically walks through the calculation that you know all about by now?
Plot twist: there are two versions of Schedule SE!
But don’t worry; it’s not complicated.
Basically, and there are some exceptions to this, but if you didn’t have a W-2 job during the year, or if you did have a W-2 job but the sum of your wages from your W-2 job plus your self-employment income is less than the statutory amount of $137,700 for 2020, you can probably use Short Schedule SE.
Otherwise, you have to use Long Schedule SE.
How to Pay Self-Employment Tax
You pay your self-employment tax just like you pay your regular income tax.
In fact, you can pay both your self-employment tax and your regular income taxes with the same check or e-payment!
The question, of course, is when you should pay your self-employment tax.
Well, you have a couple of options: you can make quarterly tax payments as the IRS prefers, or you can simply pay your entire balance when you file your tax return.
Note that the IRS generally prefers that you pay your taxes quarterly, and if you don’t, they might penalize you.
How to Avoid or Reduce Your Self-Employment Tax
The self-employment tax can be quite burdensome.
Just think of it: let’s say you’re single and in the modest 22% tax bracket, making $50,000 a year from your business.
If you live in a high-tax state like California, you could be in an 8% tax bracket for state income tax purposes.
So just considering regular income taxes alone, you’re looking at paying 30 cents on your next dollar of business income.
Add on the self-employment tax, and you could be looking at a 40-45% marginal tax rate on your next dollar of income from your business.
This makes it extremely important for you to look for tax savings opportunities wherever you can.
Below are some pointers on how to avoid or reduce your self-employment tax.
Consider an S Corporation
If you’re making at least $40,000 in your business, it may be time to form a separate business entity for tax purposes to run your business in.
An S corporation is a favorite among many small business owners because with an S corporation, only a portion of your earnings — the portion that you designate as wages — is subject to FICA tax.
Now, the important thing is that the salary you pay yourself out of your S corporation is “reasonable” for the services that you, as an employee of your own S corporation, perform.
Keep Good Records and Maximize Deductions
You can’t deduct something against your self-employment income if you don’t know what it is.
This is why keeping good books and records is essential to minimizing your self-employment tax.
There are awesome, affordable online tools like QuickBooks Online and Xero that can make bookkeeping so easy for you.
Get a Raise at Your W-2 Job
Remember how near the beginning of this article I told you that employers cover half of their employees’ FICA tax?
And also remember how I told you that for 2020 the limit on earnings subject to Social Security earnings is $137,700?
This means that if you have a W-2 job, and you can bump up your salary a bit, this could mean that less of your self-employment earnings are subject to the Social Security tax.
Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in July 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.