Definition
Self-Employment Tax refers to the taxes that self-employed individuals must pay towards Social Security and Medicare, which are typically withheld from employees’ earnings. It is calculated based on net earnings from self-employment and is determined by completing Schedule SE (Self-Employment Tax) with the U.S. Federal Tax Return. Essentially, it is the equivalent of the contribution employers and employees make towards these benefits, but made by self-employed individuals.
Key Takeaways
- Self-Employment Tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.
- Self-employed people must pay both the employer and employee’s portion of the tax, although half of what’s paid can be deducted when calculating the income tax.
- As of 2020, the Self-Employment tax rate is 15.3% – 12.4% for Social Security (up to an income ceiling) and 2.9% for Medicare.
Importance
Self-Employment Tax is a crucial finance term, primarily significant to individuals who work for themselves such as freelancers, sole proprietors, and independent contractors.
This tax is important because it encompasses both the employer and employee portions of Social Security and Medicare taxes, which a self-employed individual is responsible for paying.
Understanding Self-Employment Tax is fundamental since it directly impacts a self-employed person’s net income and their liabilities when filing taxes.
Lack of knowledge about this tax can lead to unexpected liabilities, so proper planning and estimation can help the self-employed manage their finances effectively, ensure legal compliance with tax laws, and secure their future by contributing to societal security net programs.
Explanation
The self-employment tax symbolizes the combined contributions toward Social Security and Medicare that self-employed individuals are mandated to pay. Just as employees and employers both make contributions to these two programs, self-employed individuals are required to pay both portions.
In effect, self-employment tax serves to ensure that these workers can access the same social benefits as other employed members of society. Its purpose is to financially support the systems that provide necessary benefits to individuals at different stages of their lives.
The tax is used to fund government-sponsored services such as retirement benefits, disability benefits, healthcare and hospital insurance. It is essentially a form of insurance that self-employed individuals pay for themselves.
With the standard work landscape changing dramatically and more individuals opting for self-employment, this tax ensures that these workers are also contributing to, and thereby entitled to, these social safety nets. Despite the extra tax burden, self-employment tax is a necessary tool, equipping individuals for unanticipated future needs and expenses.
Examples of Self-Employment Tax
Self-Employed Graphic Designer: A person who works independently as a graphic designer can be considered as a self-employed individual. They are responsible for their own business expenses and profits. This person should file their revenue on a Schedule C form and pay self-employment taxes (SE tax), which include both Medicare and Social Security taxes. The SE tax is calculated on their net earnings.
Freelance Writer: Freelancing is one of the clearest examples of self-employment. A freelance writer, for example, would report their income, deduct their business expenses, and then calculate and pay the SE tax based on their net earnings (income after expenses). This is important for the writer to access future Social Security and Medicare benefits.
Independent Contractor in Construction: An independent contractor who is hired on a project basis to handle construction jobs operates their own business and therefore is considered self-employed. They are responsible for their own equipment, insurance, and taxes, including the self-employment tax. The contractor must report all income and expenses on their tax return and pay SE tax on their net earnings.
FAQs about Self-Employment Tax
1. What is Self-Employment Tax?
Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.
2. Who needs to pay Self-Employment Tax?
You must pay self-employment tax and file Schedule SE (Form 1040 or 1040-SR) for the year you had net earnings from self-employment of $400 or more. This applies even if you are retired, have a pension, or you’re getting social security benefits.
3. How do I calculate my Self-Employment Tax?
The self-employment tax is calculated by taking your total ‘net farm income or net business income’ and then multiplying that number by 15.3% (12.4% for social security tax and 2.9% for medicare tax).
4. Can I lower my Self-Employment Tax?
Yes, there are specific business expenses that you can deduct on your tax return to lower your tax liability. You can also establish a retirement plan to reduce taxes.
5. Where can I get more information on Self-Employment Tax?
You can get more information on Self-Employment Tax by visiting the IRS’s official website or consulting with a qualified tax professional.
Related Entrepreneurship Terms
- Independent Contractor
- Schedule SE (Form 1040)
- Sole Proprietorship
- Estimated tax payments
- Net Earnings from Self-Employment
Sources for More Information
- Internal Revenue Service (IRS) – Offers information about U.S. federal tax laws, including those related to self-employment.
- Investopedia – Provides a wide range of educational articles and definitions about finance and investing, including explanations of self-employment tax.
- U.S. Small Business Administration (SBA) – Provides resources and guidance to assist small businesses, including information about self-employment taxes.
- H&R Block – Offers tax preparation services and educational resources about all types of taxes, including self-employment tax.
