Chances are if you are reading this, then you are already self-employed or interested in becoming a small business owner. Congrats! However, it’s important to consider self-employment taxes if this is you.
Self-employed means you fit any of the following:
- You carry on a trade or business as a sole proprietor (single-member LLC included) or receive income as an independent contractor (a 1099-Misc).
- You are a member of a partnership that carries on a trade or business. Keep in mind, partnerships must file a separate partnership return in addition to each partner’s individual income tax return.
- You are otherwise in business for yourself, including a part-time business such as graphic designer, publish a blog/vlog, gate guard, software engineer, etc.
Self-Employment Tax Obligations
As a self-employed individual, you are required to pay estimated quarterly taxes. These payments will cover your self-employment tax (SE tax) and any personal income taxes you might owe for the year.
Let’s step back and understand the breakdown of self-employment tax. Self-employment tax is the Social Security and Medicare tax. Self-employment taxes are bundled into your total tax owed at the end of the year on a tax return. This means your total tax liability includes self-employment taxes as well as your personal income tax.
As an employee, you pay half of the Social Security and Medicare taxes (7.65% of your wages) while your employer pays the other half. These taxes come directly out of your paycheck without you evening having to notice or think about it. However, as a self-employed individual, you are both employEE and employER. Therefore, you are responsible for ALL the Social Security and Medicare taxes (15.3% of your “net profit”).
Currently, the IRS has a cap on income for Social Security. For 2019, this is $132,900. This means you only need to pay the Social Security portion of self-employment tax on any profit up to this income limit.
When considering self-employment taxes, you should consider how much to save and also how much to pay yourself. I wrote a whole separate post about paying yourself as an entrepreneur if you’d like to learn more about that.
Keep in mind you must pay the self-employment tax even if you don’t have enough income after deductions and credits to owe income tax!
Calculating net profit
Before you can determine if you are subject to self-employment tax, you must calculate your net profit or net loss from your business.
Net profit (loss) = income – expenses
Business income = $65,000
Business expenses = $15,000
Net Profit = 65000 – 15000 = $50,000
The $50,000 is the amount you would use to calculate any self-employment tax.
Quarterly Tax Payments
Quarterly tax payments are due April 15, June 15, September 15, and January 15 (the following year). A trusted tax professional can help create estimates for you based on prior year income and current year earnings. It’s fine to pay different amounts per quarter based on income earned during that time frame.
If your business earns nothing in the first quarter, then you can opt out of the first quarter payment. Consequently, if your business earns a larger amount in the 4th quarter, then pay more tax January 15th. You can make the final decision about how much tax to pay each quarter, but make sure the total is enough to satisfy your tax liability or be ready to pay come tax time.
Lastly, self-employment taxes for sole proprietors and partners are partially deductible on your personal income tax return (Form 1040). Since employers typically pay half of these taxes, the IRS allows you to take half of your self-employment tax as a deduction on your personal income Form 1040.
Anything is helpful when it comes to lessening your tax burden, right?
How do you calculate what you’ll owe?
The United States income tax system is a pay-as-you-go tax system. This means that you must pay income tax as you earn or receive any income throughout the year. You do this either through withholdings on your paycheck, usually done by your employer, or by making estimated tax payments.
Self-employment income tax is 15.3%, so figure out any net profit you have and then you’ll know how much to pay. Simple, right?
Not quite. The IRS allows for a deduction of half your self-employment taxes. You’ll need to take this into consideration when making estimated payments.
Here’s the formula:
Net profit from your business X 92.35% (.9235) = business income subject to self-employment tax
If this calculation is less than $132,900, then you’ll use this formula:
your business income subject to self-employment tax X 15.3 % = self-employment tax obligation
If this calculation is over $132,900, then you’ll use this formula:
your business income subject to self-employment tax X 2.9 % + $16,479.60 = self-employment tax obligation
If you’d prefer, you can use the IRS Schedule SE worksheet to calculate your self-employment tax obligation.
Personal Income Tax as part of self-employment taxes
Personal income tax is a little more difficult because you need to factor in any deductions or credits you get to take to know your income tax bracket. You can pay according to the prior year’s tax bracket. However, if your income increases or decreases significantly, this might not be helpful.
Here are the 2019 tax brackets to give you an idea of where you might fall. Again, make sure to factor in any deductions or credits when computing personal income tax.
Generally, most taxpayers avoid any underpayment penalty if they either owe less than $1,000, or if they pay at least 90% of the current year tax, or 100% of the tax shown on your prior year return, whichever is smaller. If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.
Simply put, you must pay (whichever is less)
- at least 90% of your current year tax OR
- 100% of the tax from the prior year
Saving for taxes
Generally, I advise my clients to have a separate account for tax savings. With each paycheck or contractor payment I suggest putting aside 20-25% into this separate tax savings account. When it comes time for your quarterly payment, you have the money already set aside and ready to go.
If you end up having extra in this savings account, score!
What don’t you understand about self-employment taxes?