DEFINITION of '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.

BREAKING DOWN '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 an individual is self-employed, she is both the company and the employee, so she pays 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 s/he is considered to be both an employer and an employee. The Social Security tax is only applied to the first $128,400 of self-employment income earned, for a maximum tax of $15,921.60 (as of 2018).

The Medicare tax rate is 2.9%. Total self-employment tax rate is, therefore, 12.4% + 2.9% = 15.3% (as of 2018). So, a self-employed person having net income of exactly $128,400 in 2018 would have to remit taxes of $19,645.20 = $128,400 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 gets charged on a taxpayer’s business profit, the IRS lets him or her 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.

Individuals typically pay self-employment tax on 92.35% of their net earnings, not 100%. For example, Ike, who runs a HR Consulting business, calculates his total net income for the year 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. Since this amount is above the capped limit, his tax bill will be 15.3% x $128,400 = $19,645.20. Ike can claim an above-the-line deduction for half of his self-employment tax, or $19,461.60 ÷ 2 = $9,730.80. In effect, he gets a refund on the employer portion (6.2% Social Security + 1.45% Medicare = 7.65%) of his self-employment tax.

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. 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.

RELATED TERMS
  1. Self-Employed Person

    A self-employed person is an independent contractor or sole proprietor ...
  2. Self Employed Contributions Act ...

    The Self-Employed Contributions Act (SECA) tax is a form of taxes ...
  3. Estimated Tax

    Estimated tax is a periodic advance payment of taxes based on ...
  4. Freelancer

    A freelancer is an individual who earns money on a per-job or ...
  5. Federal Insurance Contributions ...

    Federal Insurance Contributions Act (FICA) is a US payroll tax ...
  6. Tax Base

    A tax base is the amount of assets or income that can be taxed.
Related Articles
  1. Retirement

    How Social Security Works for the Self-Employed

    As someone who is self-employed, you still have to pay into Social Security; however, there are deductions that can help lighten the tax burden.
  2. Taxes

    10 Tax Benefits for the Self-Employed

    Running your own business has both personal and financial perks.
  3. Retirement

    Understanding Your FICA Payments

    The Federal Insurance Contributions Act is a U.S. law that requires a paycheck deduction be paid to Social Security and Medicare.
  4. Personal Finance

    Calculate Your Self-Employed Salary

    Deciding on a salary is tough when you're self employed. There are several factors to consider before setting a price on your services.
  5. Retirement

    Work in the Gig Economy? Don't Miss Out on Retirement Savings

    Here are 5 smart ways the self-employed can save for retirement. Don't miss out – and get financial advice before picking a strategy.
  6. Retirement

    Is there a way to opt out of Social Security?

    Understand more about the purpose of the Social Security system and learn which groups of taxpayers are automatically exempt from the tax.
  7. Small Business

    Retirement Plan Comparison for the Self-Employed

    It's important for business owners and self-employed individuals to save for retirement, and with so many plans available, there is no reason not to.
  8. Financial Advisor

    Financial Planning for the Freelancer

    While freelancers have greater autonomy, they also face different financial challenges. Here are some tips on financial planning for the self-employed.
  9. Taxes

    Why Do So Many People Fall Behind On Their Taxes?

    Despite the threat of owing thousands of dollars to possibly the most feared organization in the U.S., millions of Americans continue to fall behind on their taxes.
RELATED FAQS
  1. How is Social Security tax calculated?

    Were you ever confused about your social security tax? Find out how it is calculated, including the impact of the Medicare ... Read Answer >>
Trading Center