What is self-employment tax?
Don’t get surprised by self-employment tax. When you are an employee of a company, you get three types of federal taxes withheld from your paycheck: income tax, social security tax and medicare tax. When you are self-employed, you no longer have these taxes withheld from your paycheck. You are now responsible for paying them to the IRS directly! Most everyone understands they owe income tax on what the earn. But many small business owners are surprised to find out they owe the IRS additional taxes above and beyond the income tax. This additional tax is called self-employment tax.
How much is self-employment tax?
The self-employment tax is how you pay in to social security and medicare. The IRS requires you to pay these taxes on the NET income of your business. The social security portion is 12.4% and the Medicare portion is 2.9%. Together they total 15.3%. The IRS allows you deduct half of these taxes, so the net you will actually have to pay is just over 14%. In addition to income tax on the net profit of your business, you will also pay an additional 14% to the IRS for social security and medicare taxes.
Here is an example
Let’s say you’re single, self-employed and make a net profit of $50,000 for the tax year. Your income tax due to the IRS will be approximately $2,500 (under the Tax Cuts and Jobs Act). Most people expect to pay this income tax. In addition to this, you will owe self-employment tax of $7,000. The total tax you will have to pay the IRS is $9,500. Imagine how surprised you would be if you did not know about self-employment tax! Don’t get surprised by self-employment tax. This is how many small business owners get behind on their taxes with the IRS. That is NOT a situation you want to be in. Planning and saving for these taxes are a very important part of your financial success.
More details you should know
As with any tax rule, there are more details you might want to understand. The first one is that there is a limit to the amount you have to pay for social security tax. Every year the government sets a limit on how much of your income is subject to the social security tax. For 2023 this limit is $160,200. Any business profits you make that exceed this amount will NOT be subject to the 12.4% portion of the self-employment tax. Most small business owners make less than this and will not reach the limit. But if your business is more successful, this is a good thing to know. Unfortunately, there is no such limit on the amount of income subject to the 2.9% medicare portion of the tax. You will pay medicare tax on every single dollar of profit you make.
Why is self-employment tax so much?
You might be wondering why when you were employed by a company, they did not withhold this much for social security and Medicare. When you are an employee, you and the company each pay half of the social security and medicare taxes. Your employer pays in 7.65% from their pocket and you pay in 7.65% from your paycheck. Now that you are self-employed, you are both the employer and the employee, so you have to pay in both halves – the full 15.3%. To be perfectly honest, you will end up paying more tax out of your own pocket as a self-employed person because of the extra 7.65% you pay in to social security and medicare. Don’t be surprised by self-employment tax. This is why it is so important to estimate and plan for your taxes ahead of time!