Being self-employed is probably a dream come true. You get to work for yourself without answering to anyone else, and it feels good to see your hard-earned profits in your bank account.
But self-employment taxes can put a damper on that feeling of freedom and satisfaction. You might be surprised at the tax burden of owning your own business, even if you don’t have a large or very profitable venture.
If you’re new to self-employment and wondering about your tax liability and other factors that influence self-employment, arm yourself with knowledge. You might be surprised to learn there are more ways to reduce your tax burden and claim credits than you might have initially thought.
Here are a few things to understand about self-employment taxes and how they apply to your life.
1. Self-Employment Tax Defined
The majority of employees are taxed based on their salaries and wages. Their earnings and taxes are reported on a W-2 prepared by their employer. But if you own your own business, are a contractor or freelancer, or otherwise work for yourself, you’re responsible for paying self-employment taxes.
By IRS standards, self-employment tax only refers to what’s owed to Social Security and Medicare and is collected from individuals who are self-employed. This has been the standard since 1954 when the Self-Employed Contributions Act (SECA) was formed. It was in response to self-employed taxpayers evading paying Social Security and Medicare after the U.S. government passed the Federal Insurance Contribution Act (FICA), which is where our Social Security and Medicare funds began.
The SECA tax (more commonly called self-employment tax) is the same for all employers and employees, but when you work for someone else, the employer pays half and you pay half. When you work for yourself, you’re responsible for the full amount.
2. The Self-Employment Tax Rate
The SECA tax is worth 15.3 percent of your net earnings; 12.4 percent goes to Social Security and 2.9 percent goes to Medicare. However, not all of your net earnings are taxed for Social Security; there’s a limit to your taxable net earnings.
In 2019, the limit for taxable net earnings is $137,000. Anything you make above that amount is not subject to self-employment tax.
So, if you made $200,000 in net earnings for the 2019 tax year, you’ll only owe 12.4 Social Security percent tax on the first $137,000. The remaining $63,000 is not taxable.
There is no limit for Medicare tax—all of your net earnings will be taxed at the 2.9 percent rate in 2019. So, if you make $200,000 in net earnings, you’ll owe 2.9 percent, or $5,800 in Medicare tax for the year.
There’s also an additional 0.9 percent tax owed after the Affordable Care Act was instituted in 2003. This applies to the first $200,000 that you make, so at $200,000 net earnings, the entire sum is taxable.
3. Quarterly Payments
For self-employed individuals, the tax liability can be quite overwhelming, especially if the bill must be paid all at once at the end of the year. To help break up your tax payments and help you make payments on time, you can make estimated quarterly payments.
Every quarter, you’ll estimate your tax liability based on your earnings for the last quarter. You’ll fill out a quarterly payment voucher, known as Form 1040-ES, and send a fat check to the IRS on or before the due date. Any overpayment will be refunded when you file your return.
The deadlines for quarterly taxes are:
- Quarter 1: April 15
- Quarter 2: June 15
- Quarter 3: September 15
- Quarter 4: January 15
If the deadline falls on a weekend, the deadline will be moved to the next business day.
Most self-employed individuals choose to pay quarterly tax, but generally, if you believe you’ll owe $1,000 after withholding and tax credits, you should pay quarterly estimated taxes. As long as the amount paid quarterly covers at least 80-90 percent of your liability, you’ll be penalty-free.
However, you may be penalized if you don’t pay quarterly taxes or if you pay them late. This penalty does not apply to everyone, and it varies according to what you owe and when you pay. Those who have low net earnings will owe a very low penalty, if any at all. Refer to the IRS website to understand your potential tax penalty.
You may be able to waive the penalty altogether if you have an uneven income and make unequal payments throughout the year. Those who are retired and over the age of 62 may avoid penalties for skipping estimated payments. Natural disasters, casualties, and unusual circumstances could eliminate your penalty, too.
4. Taking Deductions
It’s very difficult to subsist on a meagre self-employment income with a 15.3 percent tax rate, so the best way to minimize your tax liability is to take qualified deductions. Each deduction lowers your taxable income, lowering what you pay.
You might be surprised at how many deductions you can take. Here are a few deduction suggestions:
- Home office
- Health insurance
- Vehicle use
- Startup costs
- Equipment expenses
- Retirement plan contributions
- Interest payments
The list could go on and on. Basically, anything you pay for that relates directly to your business can likely be deducted from your taxable income.
Some expenses can be deducted for 100 percent of their worth while others can only be partially deducted. For example, only 50 percent of the cost for business meals can be deducted from your taxable income while 100 percent of a phone bill used exclusively for business can be deducted.
Finding all the relevant tax deductions for your business can be difficult if you don’t have experience, so it’s helpful to work with a licensed CPA to make sure you don’t forget anything. They can help you think of expenses that you may have forgotten.
It’s always a good idea to keep receipts and write down everything that you deduct from your business in case of an audit.
5. Finding Tax Credits
Tax credits can also reduce your tax liability by directly reducing the amount you owe. Usually, tax credits are given to businesses that hire certain individuals, take energy efficient steps, or participate in certain programs. There are several tax credits the IRS allows you to take including:
- General Business Credit
- Investment Credit
- Work Opportunity Credit
- Disabled Access Credit
- Energy Efficient Home Credit
- Alternative Motor Vehicle Credit
- New Market Credit
The list continues with details as to who qualifies on the IRS website.
6. Incorporating Your Business
Many self-employed individuals don’t realize that incorporating a business, which has added expenses, actual minimizes their self-employment tax liability. If you incorporate as a sole proprietor, partner, or LLC and pay yourself a reasonable salary, you’ll only pay Social Security and Medicare taxes on the salary you receive.
The keyword is reasonable salary. You can’t give yourself a salary of $1 a year and avoid taxes altogether.
7. Filing Self-Employment Taxes Correctly with Taxfyle
To stay in operation, it’s vital that you file your taxes properly at the end of the year as a self-employed business owner. However, it’s not as simple as filing your own personal taxes. There are dozens of considerations including your employees, deductions, contributions, insurance, and so much more.
It’s highly recommended that you use a licensed CPA to file your taxes for you. At Taxfyle, we have dozens of CPAs, and we can connect you with a tax preparer well-versed in filing self-employment income taxes. We know all the best deductions and credits to lower your tax burden, we can answer all of your questions, and we can help you get a great refund quickly.
To try our services, get started today!