When you work as an employee for someone else, that company or organization takes Social Security taxes out of your paycheck and sends the money to the Internal Revenue Service (IRS). In 2019, the Social Security tax rate is 6.2%, plus 1.45% for Hospital Insurance (commonly known as the Medicare tax); so, if your annual salary is $50,000, the amount that will go to Social Security over the course of the year is $3,100, plus $725 for a total of $3,825.
Your employer will match an additional $3,825 over the course of the year, and it will also report your Social Security wages to the government. When you retire, or if you become disabled, the government will use your history of Social Security wages and tax credits to calculate the benefit payments you’ll receive.
What Happens When You’re Self-Employed?
The process is a bit different if you are self-employed. You’re both the employee and the employer, so it’s your responsibility to withhold Social Security from your earnings, contributing the employer’s matching portion of Social Security as well as the individual's portion. But instead of withholding Social Security taxes from each paycheck – many self-employed people don’t get regular paychecks, after all – you pay all the Social Security taxes on your earnings, both your personal contribution and your business' contribution, when you file your annual federal income tax return.
Schedule SE, Self-Employment Tax, is where you report your business’s net profit or loss as calculated on Schedule C. The federal government uses this information to calculate the Social Security benefits you’ll be entitled to later. Self-employment tax consists of both the employee and employer portion of Social Security (6.2% + 6.2% = 12.4%) and the employee and employer portion of Medicare (1.45% + 1.45% = 2.9%), which makes the total self-employment tax rate 15.3%.
It may seem like you’re getting the short end of the stick because you have to pay both the employee and the employer portion of the tax, but you’re actually not: Economists agree that employees lose out from the employer part of the Social Security tax because it represents money their employers could otherwise pay them.
Self-Employed Tax Deductions
On Schedule SE, you multiply your business’s net profit or loss as calculated on Schedule C by 92.35% before calculating how much self-employment tax you owe. If your Schedule C profit was $100,000, you’d only pay the 12.4% combined employee and employer portion of Social Security tax on $92,350. Instead of paying $12,400, you’d pay $11,451.40. This tax deduction would save you $948.60.
Half of that $11,451.40 is the employer's matching portion of the Social Security tax. It’s considered a business expense and reduces your tax liability. It’s an above-the-line deduction toward the bottom of page 1 of the form in the adjusted gross income section, where it says, “Deductible part of self-employment tax. Attach Schedule SE.” This is the same part of the tax form where you deduct traditional IRA contributions and student loan interest. Half of $11,451.40 is $5,725.70.
This business expense would reduce your taxable earnings to $94,274.40. On page 2 of Form 1040, you add the $11,451.40 in self-employment tax in the “Other Taxes” section. You also have to pay regular income tax on your $94k profit.
Besides the Social Security tax deductions you can take when you’re self-employed, there are many business expenses that can reduce your tax liability. But that can work against you when it comes to Social Security benefit calculations, which are based in part on your taxable earnings. Here is why: The more deductions you have, the lower your Schedule C income. Lowering your Schedule C income is a good way to reduce how much federal, state and local income tax you owe. However, this lower amount becomes part of your Social Security earnings history and means you may receive lower benefits in retirement than if you didn’t take those deductions.
“Business expenses reduce your overall tax, which ultimately lowers your Social Security taxes. Business tax deductions are a way of minimizing self-employment tax and Social Security taxes,” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.
Minimize Taxes Now or Maximize Benefits Later?
Should you skip some or all of the business tax deductions you’re entitled to in order to increase your future Social Security benefit? Maybe. The answer is complicated, because lower-earning business people stand to gain more in the future than their higher-earning counterparts due to the way Social Security retirement benefits are calculated.
Another important factor is where your Schedule C earnings fall compared with your previous years’ earnings. If you have a full 35-year career behind you and you’re not earning nearly as much in your current self-employed pursuits, it makes sense to take all the deductions you can, since your Social Security benefits will be calculated based on your 35 highest-earning years. In this case, you want to minimize your Social Security taxes. But if you’re currently in the high-earning part of your career, a higher Schedule C income can help you get higher Social Security benefits later.
Unless you enjoy complex math or have a top-notch accountant, however, it’s probably not worth the headache to figure out whether you’ll earn more in future Social Security benefits than you’d save by claiming all the deductions you can today.
Since we don’t know what Social Security benefit payments will look like in the future – many people expect them to be lower because of challenges in how the system is funded – you might want to go with the sure thing and take the lower tax liability today. After all, one way to lower your tax liability is to take money out of your business and put it in one of the available retirement plans for the self-employed. That’s money you’ll have a lot more control over than Social Security benefits.
“The great thing about Social Security is you cannot access it until retirement age," says financial planner Kevin Michels, CFP®, of Medicus Wealth Planning in Draper, Utah. "You can’t make early withdrawals, you can’t skip payments and you are guaranteed a benefit. However, you have only a small say in the future legislation of Social Security and how it will be affected by the mismanagement of government funds. If you have trouble saving for retirement already, then paying [as much as allowed] into Social Security may be the better option. If you are confident you can stick to a savings plan, invest wisely and not touch your savings until retirement, it may be a better idea to minimize what you pay into Social Security and take more responsibility for your retirement."
But if you’re on the cusp of not having enough Schedule C income to give you the work credits you need, it might be worth foregoing some deductions to make sure you’re entitled to Social Security at all.
Similarly, if you’re tempted to fudge lower numbers on your self-employment tax return to reduce your income tax liability, you’ll end up with lower Social Security benefits later on. If you don’t file a tax return reporting your self-employment income, you have a limited time to file a return and still get credit with the Social Security Administration for your work time and income. You must file the return within three years, three months and 15 days after the tax year for which you earned the income for which you want credit.
That means if you didn’t file a return reporting your 2017 self-employment income, you’ll have until April 15, 2020, to correct it. This grace period doesn’t exempt you from any penalties and back taxes you may owe as a result of filing late.
When You Don’t Have to Pay Social Security Taxes
If you are self-employed and earned $400 or less, you don’t owe Social Security taxes. Nor are you taxed on the portion of your wages that exceed a certain threshold; for 2019, this "wage base" is $132,900, you don’t owe Social Security taxes on the portion of your earnings that exceed that amount.
Let’s say your annual earnings were $140,000; the percentage of taxes you owe would be applied up to the first $132,900, but not on the $7,100 above that. This annual cap on Social Security taxes also applies to employees who work for someone else.
Qualifying for Social Security Benefits
Most people (anyone born in 1929 or later) need 40 Social Security work credits, the equivalent of 10 years of work, to qualify for Social Security benefits. Specifically, for every quarter when you earn at least $1,360 (in 2019; the number changes annually), you earn one credit.
Even if your business isn’t particularly successful or you only work part time or occasionally, it’s not difficult to earn the Social Security credits you need. In fact, even if your earnings fall below this threshold or if your business has a loss, there are some alternative ways to earn Social Security credits. These optional methods may increase the amount of self-employment tax you owe, but they’ll help you get the work credits you need.
Your eventual benefit payments do take your earnings into account; if you never earned much money from a lifetime of self-employment, don’t count on getting a large Social Security check in retirement. If you started claiming benefits this year, for example, and your average monthly earnings worked out to just $800, your monthly Social Security retirement benefit would be $720 – assuming you’re at full retirement age. That’s not much, but if you managed to get by on an average of $800 a month during your working years, you can probably work with a monthly benefit payment of $720 in retirement.
Certain categories of earnings don’t count toward Social Security for most people, such as stock dividends, loan interest and real estate income. By “don’t count,” we mean that you don’t pay Social Security taxes on this income and it also isn’t used to calculate your future benefits. The exception is if your business operates in one of these areas: Self-employed stockbrokers, for example, do count stock dividends toward their Social Security earnings.
The Bottom Line
In many ways, Social Security really isn’t much different whether you’re self-employed or work for someone else. Self-employed individuals earn Social Security work credits the same way employees do and qualify for benefits based on their work credits and earnings.
Business tax deductions create the biggest difference: If you work for someone else, you pay Social Security taxes on all of your earnings, up to the $132,900 cap, but if you work for yourself, deductions you claim on Schedule C can make your taxable income substantially lower. That can decrease your Social Security taxes today, but also potentially decreases your Social Security benefits later.