What Is Self-Employment Tax?

Self-employment tax is the imposed tax that a small business owner must pay to the federal government to fund Medicare and Social Security. Self-employment tax is due when an individual has net earnings of $400 or more in self-employment income over the course of the tax year. Self-employed people who make less than $400 from self-employment don’t have to pay any tax. Self-employment tax is computed and reported on IRS Form 1040 Schedule SE.

Key Takeaways

  • Self-employment tax is imposed to pay for Social Security and Medicare.
  • Workers who are considered self-employed include sole proprietors, freelancers, and independent contractors who carry on a trade or business.
  • Self-employed people who earn less than $400 a year don’t have to pay the tax.
  • The CARES Act defers payment of the employer portion of 2020 Social Security taxes to 2021 and 2022.

Understanding Self-Employment Tax

The self-employment tax is to be paid by workers who are considered self-employed. This includes sole proprietors, freelancers, and independent contractors who carry on a trade or business. A member of a partnership that carries on a trade or business may also be considered to be self-employed by the Internal Revenue Service.

In any business both the company and the employee are taxed to pay for the two major social welfare programs: Medicare and Social Security. When people are self-employed, they are both the company and the employee, so they pay both portions of this tax. Social Security tax is assessed at a rate of 6.2% for an employer and 6.2% for the employee. A self-employed worker will be taxed 6.2% + 6.2% = 12.4%, as he or she is considered to be both an employer and an employee. The Social Security tax is only applied to the first $132,900 of self-employment income earned, for a maximum tax of $16,479.6 (as of 2019). For 2020, income subject to Social Security taxes rises to the first $137, 700.

$137,700

The amount of self-employment income above which the portion of self-employment tax that pays for Social Security is no longer levied for the 2020 tax year.

The Medicare tax rate is 2.9%. Total self-employment tax rate is, therefore, 12.4% + 2.9% = 15.3% (for both 2019 and 2020). A self-employed person having net income of exactly $132,900 in 2019 would have to remit taxes of $20,334 = $132,900 X 0.153. However, earnings above $200,000 ($250,000 for married couples filing jointly) are subject to an additional 0.9% Medicare tax. The Social Security component of the self-employment tax phases out once net income reaches the low six figures, but all net income is subject to the Medicare tax. Self-employed individuals must pay self-employment tax as a condition of receiving Social Security benefits upon retirement.

Self-employment tax is a tax-deductible expense. While the tax is charged on a taxpayer’s business profit, the IRS lets them count the employer half of the self-employment tax, or 7.65% (calculated as half of 15.3%), as a business deduction for purposes of calculating the tax.

Example of Self-Employment Tax

Individuals typically pay self-employment tax on 92.35% of their net earnings, not 100%. For example, Ike, who runs a human resources consulting business, calculates his total net income for 2019 to be $200,000 after business expenses have been deducted. His self-employment tax rate will be assessed on 92.35% x $200,000 = $184,700. As this amount is above the capped limit, his tax bill will be 15.3% x $132,900 = $20,334. Ike can claim an above-the-line deduction for half of his self-employment tax, or $20,334 ÷ 2 = $10,166.85. In effect, he gets a refund on the employer portion (6.2% Social Security + 1.45% Medicare = 7.65%) of his self-employment tax.

Special Considerations

Workers who are self-employed aren’t subject to withholding tax, but the IRS requires taxpayers to make quarterly estimated tax payments in order to cover their self-employment tax obligation. However, the CARES (Coronavirus Aid, Relief, and Economic Security) Act, signed into law by the president on March 27, 2020, defers payment of the employer portion of self-employment taxes attributable to Social Security for the period of March 27, 2020, through Dec. 31, 2020. It defers payment of 50% of those taxes until Dec. 31, 2021, and the other 50% until Dec. 31, 2022.