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, similar to FICA taxes paid by an employer. 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, or $108.28 or more from a tax-exempt church. Self-employed people who make less than these thresholds from self-employment don’t have to pay any tax. Self-employment tax is computed and reported on IRS Form 1040 Schedule SE.
- 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 (or less than $108.28 from a church) 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. Self-employed individuals must pay self-employment tax as a condition of receiving Social Security benefits upon retirement.
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, in the eyes of the Internal Revenue Service (IRS), 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. Therefore, a self-employed worker will be taxed 6.2% + 6.2% = 12.4%, as they are considered to be both an employer and an employee. The Social Security tax is only applied to the first $142,800 of self-employment income earned, for a maximum tax of $17,707.20 in the tax year 2021; in 2022, it's the first $147,000 of income, for a tax max of $18,228.
Medicare tax is assessed at a rate of 1.45% for an employer and 1.45% for the employee. Therefore, a self-employed worker will be taxed 1.45% + 1.45% = 2.9%, as they are considered to be both an employer and an employee. The Medicare tax has no income limit. Total self-employment tax rate is, therefore, 12.4% + 2.9% = 15.3%. A self-employed person having net income of exactly $137,700 in 2020 would have to remit taxes of $21,068.10 = $137,700 * 0.153.
High-income earners face an additional self-employment tax. As a result of the Affordable Care Act (ACA), earnings above $200,000 ($250,000 for married couples filing jointly) are subject to an additional 0.9% Medicare tax.
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 that taxpayer's income tax.
Example of Self-Employment Tax
Individuals typically pay self-employment tax on 92.35% of their net earnings, not 100%. Robin, who runs a human resources consulting business, calculates their total net income for 2020 to be $200,000 after business expenses have been deducted. Their self-employment tax will be assessed on 92.35% * $200,000 = $184,700. This amount is above the capped limit for the Social Security portion of the self-employment tax. Therefore, Robin's self-employment tax bill will be (12.4% * $137,700 = $17,074.80) + (2.9% * $184,700 = $5,356.30) = $22,431.10.
When Robin files their 2020 income tax return, they can claim an above-the-line deduction for half of their self-employment tax, or $22,431.10 ÷ 2 = $11,215.55. In effect, they get a deduction on the "employer" portion (6.2% Social Security + 1.45% Medicare = 7.65%) of their 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, in addition to their federal and state income 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.