Many workers hope to strike out on their own and be their own boss. Yet even though running your own business can be intensely satisfying, it also brings with it new burdens that regular employees never have to worry about. In particular, taxes on the self-employed can be much more onerous than on ordinary workers. There are, however, ways you can reduce what you'll have to pay in self-employed taxes. Let's take a closer look at exactly what taxes you have to pay as a self-employed person and what you can do to reduce your overall tax bill.
2 taxing roles
The biggest burden that self-employed people take on with taxes involves Social Security and Medicare payroll taxes. Most employees have money withheld from their paycheck, with 6.2% of your wages going toward Social Security taxes and 1.45% for Medicare taxes. What many people don't know, though, is that your employer also pays an equal amount on your behalf.
When you're self-employed, you have to pay both the employer half and the employee half of these taxes. As a result, you'll typically pay a total of 15.3% of your wages up to the maximum Social Security wage base, which for 2015 is $118,500. Above that amount, the rate on self-employed taxes falls to 2.9%.
Dealing with estimated tax payments
In addition to payroll taxes, self-employed individuals typically have to make sure they pay enough in taxes throughout the year. Ordinary workers have income tax withheld from their paychecks, and their employers forward the withheld amounts to the IRS throughout the year. Without an employer, you're responsible for following the rules governing minimum estimated tax payments, and if you don't pay enough, you'll owe a penalty.
Typically, the self-employed make quarterly estimated tax payments, with the choice to base those payments on the income either from the previous year or from the current year. The most important thing to remember is that when you get money in from your customers, earmarking some of it toward your tax liability is crucial to make sure you'll have enough when those quarterly deadlines hit.
Reducing the tax burden
The upside of self-employed taxes is that they're imposed on your net profit after allowable deductions. As a result, if you have legitimate business expenses, you can claim them against your self-employment income, and you'll only pay income tax and payroll taxes on the net income amount rather than on your gross proceeds.
Of course, that doesn't mean you can simply deduct everything. The more aggressive you are with business deductions, the greater the likelihood that you'll get audited. Nevertheless, with deductions available for everything from home-office expenses to supplies, equipment, and travel, it can be far easier to reduce your taxable income as a self-employed person running your own business than it is as a regular worker to convince your employer to reimburse you for the costs you incur doing your job.
Another way to reduce self-employed taxes is more complex but can have a big payoff. If you organize your business as a sole proprietorship, partnership, or LLC, then self-employed payroll taxes are taken on your entire profit. If you incorporate your business as an S corporation, however, you're allowed to declare a portion of your income as salary and the rest as a profit distribution, and you only have to pay payroll taxes on the salary portion. It's essential not to abuse this provision and instead to pay yourself a reasonable wage. However, paying less than your total profits in salary is a common and often acceptable way to reduce your self-employed tax liability.
Be smart about self-employment
Being self-employed involves dealing with a host of complicated tax issues. You'll have a much greater chance of success in navigating the tougher aspects of running your own business if you're aware of tax issues upfront, which prepares you to take advantage of the favorable aspects of tax provisions while avoiding the costly traps that many self-employed business owners fall into.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.