Many self-employed individuals are shocked and dismayed when they see their annual income tax bill. This is because they must pay self-employment taxes in addition to income taxes. Many feel that they are being unfairly taxed compared to other people. However, there’s more to the story. This article describes the self-employment tax and shows how it compares to the taxes paid by wage earners.
Self-employment tax is another way that the government collects taxes for Social Security and Medicare. Here’s how these taxes apply to employed vs. self-employed people.
Consider the tax situation of Sarah, who works for Local Store. She is paid a salary and certain taxes are taken out of her pay before she receives it. Two of these deductions are the FICA (or Social Security) tax and the Medicare tax. If Sarah earns a salary of $1,000.00 for a pay period, she does not get a check for $1,000.00. Her paycheck has, at a minimum, deductions of $62.00 of Social Security tax and $14.50 of Medicare tax for a total of $76.50. The maximum check issued is $923.50.
In addition, the government requires her employer, Local Store, to pay an equal amount of $76.50 to Social Security on her behalf. At tax time, Sarah pays income tax on the income of $1,000.00. However, Sarah’s Social Security account actually has $153.00 added to it ($76.50 deducted from Sarah’s pay and $76.50 paid by Local Store). Local Store sends the government the additional $76.50 and also gets an income tax deduction for that business expense.
In contrast, let’s consider the tax situation of Carla, who is an electrician and owns her own business. If she receives a payment for $1,000.00 from a customer, she gets the entire amount of $1,000.00. Since Carla doesn’t receive pay from an employer, neither FICA nor Medicare tax is deducted from the income she receives. Carla must pay these taxes on her annual income tax return.
The total amount paid in to Social Security is actually about the same for the wage earner (Sarah) and the self-employed person (Carla). However, Carla feels it as more of a burden because she pays both the worker’s and the employer’s halves of the tax and it is due all at once. Here’s how it works for Carla.
At tax time, she must pay the Social Security taxes due on that $1,000.00 of income. The self-employment (SE) tax due on the $1,000.00 is $141.00. The SE tax form uses some fancy math to simulate the business deduction. At first glance, it looks like the self-employed person is paying almost twice as much as the wage earner. Remember that in self-employment, the individual is not only the worker, but also the business owner. Self-employment tax is the total of the employee contribution and the employer contribution. To make things equal, Carla’s 50% “employer” contribution ($71.00), of the SE tax is a deduction on the first page of her federal income tax return. Carla, the self-employed person, declares $1,000.00 of income, but subtracts $71.00 and so pays tax on $929.00. In addition to income taxes, she must pay $141.00 in SE tax, but remember she got the entire $1,000.00 when the customer paid Carla.
In the end, each of the individuals gets credit for $1,000.00 of taxed income in her Social Security account. Sarah and Local Store pay $153.00 total to have this occur, while Carla pays $141.00. In a way, the amount that Local Store pays for Sarah is like “hidden” income to her. Local Store considers that amount to be part of what it costs to employ Sarah. If the store didn’t have to pay that tax, Sarah could receive it as part of her pay. So, actually Sarah’s pay is a little lower than what it would be if Local Store didn’t have to pay that tax.
NOTE: this situation is one reason that self-employed people cannot realistically compare their hourly or weekly pay to a person who works for a company. Self-employed people NEED to earn more per hour because they pay both sides of the Social Security tax in addition to other business expenses such as health insurance, equipment, etc.
Sarah never sees Local Store’s side of the tax because it is taken out before she gets paid. Also, even her side of the tax never reaches her hands and is deducted paycheck by paycheck. It’s a moderate trickle that she mostly ignores. On the other hand, Carla, the self-employed person, accounts for all of the earnings once per year and that can create a large tax bill on April 15. Self-employed persons usually need to make quarterly estimated tax payments but, even so, Carla can receive an unpleasant shock on April 15 if she has not carefully calculated the payments through the year.
If you are a newly self-employed person, be aware of the financial repercussions of the SE tax and quarterly estimated tax payments.The fine print: This article is for information only. Please see your tax professional for questions about your individual tax situation.