Is Self-Employment Tax in Addition to Income Tax?
Navigate the complexities of self-employment tax. Discover its distinct nature, how it's determined, and its impact on your overall tax liability.
For self-employed individuals, understanding tax obligations includes self-employment tax. This tax ensures contributions to Social Security and Medicare, similar to payroll deductions for traditional employees. Self-employment tax is in addition to income tax, as it covers these federal insurance contributions.
Understanding Self-Employment Tax
Self-employment tax is the self-employed individual’s contribution to Social Security and Medicare, similar to FICA (Federal Insurance Contributions Act) taxes for traditional employees. Unlike W-2 employees, whose employers pay half of these taxes and withhold the other half from the employee’s paycheck, self-employed individuals are responsible for both the employer and employee portions. This means covering the full amount that would otherwise be split.
The self-employment tax rate is a combined 15.3% on net earnings from self-employment. This rate consists of two distinct components: 12.4% for Social Security, which funds Old-Age, Survivors, and Disability Insurance (OASDI), and 2.9% for Medicare, which supports Hospital Insurance (HI). These rates apply to your business’s net earnings, calculated as your gross income less allowable business deductions.
You must pay self-employment tax if your net earnings from self-employment are $400 or more in a tax year. This obligation applies regardless of your age or if you are already receiving Social Security or Medicare benefits.
Calculating Your Self-Employment Tax
Determining your self-employment tax begins with calculating your net earnings from self-employment. This figure is derived by subtracting all ordinary and necessary business expenses from your gross income generated from your trade or business. For many self-employed individuals, this net profit is typically calculated on a Schedule C (Form 1040).
Once your net earnings are established, only 92.35% of this amount is subject to self-employment tax. This adjustment accounts for the employer’s share of FICA taxes, aiming to put self-employed individuals on a similar footing as traditional employees.
The combined 15.3% self-employment tax rate (12.4% for Social Security and 2.9% for Medicare) is then applied to this 92.35% of your net earnings. The 12.4% Social Security portion of the tax only applies up to a certain income threshold, which varies annually. Earnings above this limit are not subject to the Social Security portion of the tax.
In contrast, the 2.9% Medicare portion of the self-employment tax has no income limit, meaning it applies to all your net earnings from self-employment. An additional Medicare tax of 0.9% may also apply to net earnings exceeding certain thresholds. This entire calculation process is typically performed using Schedule SE (Form 1040).
The Self-Employment Tax Deduction
Self-employed individuals can deduct a portion of their self-employment tax. Taxpayers can deduct one-half of their self-employment tax from their gross income when calculating their adjusted gross income (AGI). This deduction is specifically designed to recognize that self-employed individuals pay both the employer and employee shares of Social Security and Medicare taxes.
The deduction aims to create a more equitable tax treatment between self-employed individuals and W-2 employees. For W-2 employees, the employer’s portion of FICA taxes is not considered taxable income to the employee, and the employer can deduct it as a business expense. Allowing self-employed individuals to deduct half of their self-employment tax effectively mirrors this arrangement.
This deduction is considered an “above-the-line” deduction, meaning it reduces your adjusted gross income directly. A lower AGI can potentially lead to other tax benefits, such as qualifying for additional credits or deductions that are limited by AGI. This deduction is reported on Schedule 1 of Form 1040.
Paying Self-Employment Tax
Self-employed individuals are required to pay estimated taxes throughout the year to cover their self-employment tax and income tax liabilities. This “pay-as-you-go” system is essential because taxes are not withheld from self-employment income as they are for traditional employees. Making these payments helps avoid a large tax bill at the end of the year and potential underpayment penalties.
Estimated tax payments are typically made quarterly, with specific due dates that do not align perfectly with calendar quarters. The general due dates are April 15 for income earned January 1 to March 31, June 15 for income earned April 1 to May 31, September 15 for income earned June 1 to August 31, and January 15 of the following year for income earned September 1 to December 31. If a due date falls on a weekend or holiday, the deadline shifts to the next business day.
Several convenient methods are available for making these estimated payments. You can use IRS Direct Pay, which is a free service that allows direct payments from your checking or savings account. Another option is the Electronic Federal Tax Payment System (EFTPS), a free service provided by the U.S. Department of the Treasury that allows scheduling payments up to 365 days in advance. Payments can also be mailed with Form 1040-ES vouchers.
Failing to pay enough estimated tax throughout the year can result in underpayment penalties. Taxpayers can generally avoid this penalty if they owe less than $1,000 in tax after subtracting withholdings and credits, or if they pay at least 90% of the tax for the current year or 100% of the tax shown on the prior year’s return, whichever is smaller. Higher-income taxpayers may have a higher threshold of 110% of the prior year’s tax.