Everyone has to pay income tax, but when it comes to Social Security and Medicare taxes, employers split the cost with their employees. However, when you're self-employed, you're considered both the employee and the employer. That makes you responsible for the full Social Security and Medicare tax rates when self-employed – essentially double the rate of someone employed by a company they don't own.
Tax Rate for Self-Employment
According to the Internal Revenue Service, the tax rate for self-employment is currently 15.3 percent. Of this amount, 12.4 percent funds the Social Security program, while the other 2.9 percent funds Medicare. As of 2020, the IRS applies the 12.4 percent Social Security tax rate only to the first $137,700 earned through self-employment, but the 2.9 percent Medicare tax rate applies to your entire net income.
The IRS will also require you to pay an additional 0.9 percent Medicare tax if you earn more than the threshold amount associated with your filing status (i.e., $200,000 for single filers).
Only people who earned more than $400 in self-employed activities (or more than $108.28 in church employee earnings) need to pay the self-employment tax.
Self-Employment Tax Deductions
When calculating your adjusted gross income, you are allowed to deduct half of the self-employment tax fund. In essence, this turns the "employer" portion of the self-employment tax into a business expense and can ease some of the burden of your income taxes. However, it does not make you exempt from paying the full self-employment tax.
As a self-employed person, you are also allowed to deduct the cost of your health insurance to determine your adjusted gross income, which can also save you money on your income tax.
You may also qualify for the Earned Income Tax Credit, which is not a deduction per se but can provide some tax relief to self-employed individuals who meet the income and child requirements.
Tips for Setting Aside Tax Money
Remember that the self-employment tax occurs in addition to your income tax and that you, as your own employer, are responsible for withholding tax money from your own paychecks. One of the best ways you can ensure you have enough money to pay your taxes on time is to set up a separate savings account solely to store these funds. Get in the habit of immediately transferring the appropriate percentage of every transaction to this savings account. This will prevent you from spending money that's actually earmarked for the government.
To set aside the correct percentage, take some time to understand how income tax brackets work. For example, you'll owe only 10 percent (plus the 15.3 percent self-employment tax, for a total of 25.3 percent) on the first $9,875 you earn. But that increases to 12 percent (plus 15.3 percent self-employment tax, for a total of 27.3 percent) for the next $9,876 to $40,125. Earnings between $40,126 and $85,525 jump to a 22 percent income tax (plus 15.3 percent self-employment tax, for a total of 37.3 percent).
Don't make the mistake of withholding only 25.3 percent when you're earning a significant amount of money each year. You'll come up short when it's time to pay taxes.
Filing Your Self-Employment Taxes
Another tax difference for the self-employed is the need to estimate and pay taxes on a quarterly basis. You'll also need to file an annual tax return. If you overestimated your quarterly payments, you'll receive a check from the IRS. If you underestimated those quarterly payments, you'll need to submit payment when filing your annual return.
File Form 1040-ES to make estimated payments and file Form 1040 – and any applicable schedules as required by the instructions – for your annual tax returns. Visit IRS.gov to find each of these forms and additional information about filing self-employment taxes.
Cathy has been writing about finance since 2014 and has been published on sites like The Nest, Bizfluent, Financial Independence Hub, and Credibly. She takes a particular interest in demystifying personal finance questions, like budgeting, tackling debt, and investing for the future.