Self-employment is a big business in the United States.
About 15 million Americans are classified by the Bureau of Labor Statistics as being self-employed. Considering the US has a working-age population of around 205 million, this means that more than 7% of American adults are self-employed.
And those numbers don’t count the millions more who take on self-employment as a side gig, supplementing income from a full- or part-time job. Upwork reports that in 2020, more than one-third of American workers were freelancing at some level.
While it may be freeing to start working for yourself — a big reason freelancing is of such interest to many younger people — it also comes with some serious responsibilities and obligations.
One of the most annoying of those obligations is to the Taxman. Or Taxwoman. Taxperson?
Every April, the IRS comes calling. If you work as a traditional full-time employee, that month is the only time you really need to think about the IRS. Your employer pays the government taxes on your behalf throughout the year, and you are only on the hook to file your forms in April and pay anything you still owe. You may even end up getting money back, which really takes the sting out of this time of year.
Things aren’t nearly so simple for the self-employed out there. Not only do you need to file your estimated taxes quarterly if you’re self-employed, but a piece of those estimated numbers is comprised of self-employment tax.
Self-employment tax refers to a specific tax levied by the federal government, consisting of Social Security and Medicare taxes paid by those who work for themselves. This is a tax levied on an individual’s net earnings from self-employment.
It’s important to understand that the term “self-employment tax” does not refer to any other taxes that self-employed people are required to pay, like income tax.
Every US taxpayer pays Social Security and Medicare contributions as part of their taxes. In a traditional employment scenario, you pay half of this tax, and your employer pays the other. For 2020, the self-employment tax rate was 15.3% — composed of 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). Those who are employed full-time pay half of this amount, for a total of 7.65% (labeled FICA on the pay stub), while their employer pays the other 7.65%.
Those taxpayers who are self-employed pay both halves of this amount — the full 15.3% for 2020. This percentage applies to the first $137,700 of your combined wages, tips, and net earnings for 2020 (and will apply to the first $142,800 in 2021).
Being on the hook for a big chunk of change that most people’s employers cover for them can be a cold bath for freelancers and other self-employed people.
If you’re new to self-employment or work part-time for yourself, you may be making an income so small that you don’t actually have to pay taxes at all.
There are different thresholds that determine whether or not you have to pay taxes. For example, a single filer in traditional employment who earned less than $12,400 in gross income doesn’t have to file a tax return in 2020.
But unfortunately for self-employed people, the threshold they face is far lower. Self-employed individuals who earned any more than $400 during the year need to file a tax return. You may not actually have to pay any taxes, but you still need to file a return.
And as soon as you start needing to file, you start needing to calculate whether or not you need to pay self-employment tax.
The IRS considers you self-employed if any of the following are true:
The IRS considers you to be not self-employed if:
The IRS considers you self-employed if you work for yourself part-time, regardless of whether you have another full-time job as well. You must determine the total amount of self-employment tax you must pay in both roles and ensure you’re paying enough total.
The IRS defines passive income in two ways. Income you gain from a business that you own or partially own and that operates independently of you is passive income, as is rent money that you collect as a real estate owner.
You can earn income from either or both of these two sources without being considered self-employed. This means that you don’t have to pay self-employment tax on that money.
You will file self-employment taxes as part of your larger tax filings; it’s simply an extra number you need to calculate and include on your forms. Follow these steps and you’ll be able to file with few headaches.
Collect all your paperwork before you start doing your taxes. You’ll need the tax return you plan to file — probably Form 1040. You’ll also need to collect any other forms that show expenses like student loan interest and health insurance premiums. If you got health insurance through the Healthcare Marketplace you’ll need Form 1095-A.
You’ll also need your business records: all the payments you received and all the expenses you deducted to run your business. If you’re a freelancer, your clients who paid you more than $600 total during the year will send you 1099-MISC forms. Make sure the totals on these forms match up with your records.
Self-employment taxes are calculated from your net earnings from self-employment. That means that deductions are your friends when you file self-employment taxes.
The idea of deductions can get confusing for self-employed workers because you’ll need to account for business deductions as well as personal tax credits.
When calculating your business deductions, make sure you’re only counting things for which you have documentation and a legitimate business reason. For example, you can’t deduct a cup of coffee you bought if there was no business use for it. But you can deduct 50% of a cup of coffee that you ordered during a meeting at a café with a client. If you’re not sure if an expense qualifies as a legitimate write-off, ask a tax professional.
As a self-employed person, you may qualify for a home office deduction. To qualify, you have to dedicate a portion of your home to business use — and not use it for anything else. If you qualify, you can deduct a flat amount or a percentage of your utilities, rent or mortgage, insurance, repairs, and maintenance costs.
If you’re self-employed as a freelancer or a single-member LLC, you’ll need to fill out a Form 1040 and will report your business net income on Schedule C. If you run a separate business that is not a pass-through, like a partnership or multiple-member LLC, you’ll report business net income on Schedule K-1. All self-employed people should report their self-employment tax on Schedule SE.
After you’ve paid the IRS, you may also have to deal with state and local taxes, too. Some states, like Pennsylvania, have a flat income tax, while New Jersey has a progressive tax system where the percentage you pay goes up with your income. There are nine states that don’t have any income tax.
The good news is that you don’t have to worry about paying self-employment tax to your state or local government — it’s a federal thing. You may have other things to worry about paying, depending on where you live — like transit tax — but self-employment tax isn’t one of them.
If you’re likely to owe more than $1,000 in taxes the next time you file as a self-employed person, then you have to pay estimated taxes. This means you pay the amount you think you owe for a given quarter of the year or however much you paid for that quarter the previous year.
Because estimated taxes are meant to add up to all of the taxes you own for a given year, self-employment tax is included in those amounts. You’ll be paying self-employment tax as you go, along with your income tax.
To determine the minimum you must pay each quarter, you can take what you owed in taxes the year before and divide it by four. If it’s your first year as a self-employed person, you should estimate the amount of income you think you will earn throughout the year.
Estimated taxes are due four times throughout the year: April 15, June 15, September 15, and January 15. Yes, you must pay the estimated tax payment for the first quarter of the new tax year at the same time that you pay your annual taxes for the year before.
Use Form 1040-ES to figure out how much to pay and to file your estimated taxes. The form contains blank vouchers that you can enclose with your check if you decide to mail your estimated tax payments. Alternately, you can use the Electronic Federal Tax Payment System (EFTPS) to file your estimated taxes.
The IRS’s Estimated Taxes page has more information about filing your quarterly estimates.
If you’re a self-employed person paying estimated taxes, there’s always a real possibility you’ll end up owing more than you expected. Your earnings aren’t steady from year to year, or even from month to month, which makes it easy to miscalculate how much you should pay every quarter.
You should make sure to pay enough each quarter to total at least 90% of the tax you owe for the current year, or 100% of the tax you owed according to your previous year’s return. If you don’t pay enough estimated taxes, you may get stuck with a penalty for underpayment of estimated tax.
And what happens if you can’t pay the amount you still owe when you file your annual taxes?
Not paying your entire bill can also result in penalties. If you fear that may be your situation, don’t delay filing and end up missing the filing deadline. Instead, prepare your tax return, file it on time, and then contact the IRS to arrange an installment plan for payment.
Doing this will cost you — the IRS charges a setup fee, interest, and penalties. But it’s better than simply not paying. The penalties will be far worse if you stick your head in the sand and neglect filing, paying, or contacting the IRS when you should.
Ignoring the problem could land you with a failure-to-pay penalty or a failure-to-file penalty. These penalties add up month after month until you fix the situation.
If you get slapped with both of these penalties at the same time, you’ll be on the hook for a maximum of 5% of your tax bill. They can each accumulate to add up to 25% of your unpaid tax bill. In addition, you’ll be accumulating interest on your unpaid taxes.
Becoming self-employed can be a dream come true. You can work when you want and often from where you want. But there is a small price to pay for that freedom: You have to take care of self-employment taxes.
Don’t leave things to chance. After all, you don’t know what you don’t know. While the IRS’s Self-Employed Individuals Tax Center can help you figure your way through your taxes, these issues get complicated fast.
An easier route may be hiring a tax professional to take care of your taxes for you. Learn more about our tax preparation services today.
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