If you earned any income in 2015 that didn't have payroll and Medicare taxes deducted, you may have to pay an additional tax known as self-employment tax, which unfortunately can take another 15.3% out of your earnings. With that in mind, here are the details on self-employment tax so you'll know what to expect, and the best way to plan for next year.
What is self-employment tax?
Self-employment tax is designed to account for the fact that self-employed individuals don't have Social Security and Medicare taxes taken out of their paychecks.
When you work most jobs, your earnings are taxed at a 6.2% rate for Social Security and 1.45% for Medicare. Additionally, your employer also contributes the same amount -- a total of 7.65% of your wages. However, when you're self-employed, you are the employer and the employee. Therefore, you're responsible for paying all of the Social Security and Medicare taxes, which adds up to 15.3%. This is the self-employment tax rate.
Any earned income up to $118,500 is subject to the Social Security portion of the self-employment tax and all of your earned income is subject to Medicare taxes. So, if you earned more than $118,500, only that portion is subject to Social Security tax.
Further, if your self-employment income is in addition to another job, you'll only have to pay Social Security tax on up to $118,500 in total income. For example, if you earn $100,000 from a full-time job and another $50,000 from a business you run on the side, only the first $18,500 of your self-employment income will be subject to Social Security taxes. However, the Medicare portion of the self-employment tax will still be applicable to the entire amount.
Do I have to pay self-employment tax?
Basically, any income that doesn't already have payroll taxes withheld, and that didn't result from your investments or other passive sources is considered to be self-employment income. This applies whether you're truly self-employed or are simply paid as an independent contractor.
As a general rule, any earned income for which you receive a Form 1099, or don't receive any tax forms at all, is considered self-employment income. To name a few situations, this can include (but is not limited to):
- Income from a home-based business
- Income from a business you own, unless payroll taxes have already been deducted
- Income from freelance work
- Any income for which you are paid as an "independent contractor"
- Any other untaxed earned income
As a personal example, when I was teaching high school math I worked for a non-profit tutoring center after school to earn some extra money. Although I was working for someone else's business, I was paid hourly as an independent contractor, so the income from this job was considered self-employment income.
According to IRS rules, if your net self-employment income was more than $400, or if you earned more than $108.28 as a church employee during the tax year, you must pay self-employment tax. You can use IRS schedule C or C-EZ to determine your net self-employment income, and you'll use schedule SE to report it on your 1040.
Is all of my self-employment income subject to the tax? Is there any way to avoid self-employment tax?
Almost all of your net self-employment income is subject to self-employment tax. You can deduct the employer's portion of self-employment taxes from your net income before you apply the 15.3% multiplier. That may sound confusing, but the result is that you can multiply your net self-employment profit by 92.35% (0.9235) before calculating your self-employment tax.
Also, note that net self-employment income is what you earned after all allowable business deductions are taken out. Just to name a few things, if you bought new office furniture, used your car for business purposes, or took some business trips, these expenses can all generally be deducted from your self-employment income; hence you won't need to pay self-employment taxes on money used for these purposes.
Other than the two items I just mentioned, there's really no way to avoid the self-employment tax.
Some good news (sort of)
To ease the pain of the self-employment tax, you can use one-half of the amount of SE tax you pay as a deduction from your taxable income on your 1040. Now, this does nothing to reduce your self-employment tax, but depending on your marginal tax rate (your tax bracket), this can be a pretty nice deduction.
For example, if you paid $10,000 in self-employment tax in 2015, you can deduct $5,000 of this amount from your taxable income.
You may need to make quarterly payments
If you anticipate owing self-employment tax, you may need to make quarterly estimated tax payments to the IRS. Each estimated payment should be equal to one-quarter of your total projected tax liability for the year. It doesn't need to be a precise amount -- that's why they're called "estimated" tax payments. However, failure to do so can result in a penalty in addition to a massive tax burden at the end of the year, depending on how much you end up owing and how long you've owed it for.
Officially, the threshold for being required to make estimated tax payments is an expected tax liability of $1,000 or more for the year after all other withholdings. If your federal income tax withholdings are expected to cover 90% of your total tax liability or more, you don't need to make estimated payments, regardless of the $1,000 guideline.
A general rule of thumb is to use last year's tax liability to determine your estimated payments. For example, if your federal income tax for 2015 was $15,000, and a total of $11,000 was withheld from your paychecks throughout the year, this leaves a tax liability of $4,000. So, for this year, you can use $1,000 as a quarterly estimated payment amount.
Calculating self-employment tax -- an example
Let's say that you run a home-based business, and that your net profit for 2015 was $80,000. First, to figure out your taxable self-employment income, multiply this amount by 0.9235, which produces $73,880. Applying the 15.3% tax rate to this amount shows a self-employment tax of $11,303.64. Finally, keep in mind that half of this amount, or $5,651.82 is deductible from your taxable income on your 1040.