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

    Self-employed is a situation in which an individual works for ...
  3. Social Security Tax

    The tax levied on both employers and employees to fund the Social ...
  4. Self Employed Contributions Act ...

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

    A payroll tax is a tax an employer withholds from an employee's ...
  6. Annualized Income

    Annualized income is an estimate of the amount of money that ...
Related Articles
  1. Insurance

    The Hidden Costs Of Self-Employment

    If you are self-employed, vacation time, health benefits, insurance and taxes are all things you will have to deal with on your own.
  2. Taxes

    10 Tax Benefits for the Self-Employed

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

    Retirement Planning for the Self-Employed

    The three retirement-savings options best suited to the entrepreneur.
  4. Taxes

    How to File Your Child's First Income Tax Return

    Use this quick parental guide to help your child learn the tax-filing process and establish good habits.
  5. Retirement

    Savings Options for the Self-Employed Millennial

    Self-employment has many advantages, but one of the disadvantages is the lack of a company-sponsored retirement plan. Here are some other options.
  6. Taxes

    Estimated Taxes Tripping Up More Filers

    If your working as an independent contractor, making sure you cover your bill for estimated taxes is important for avoiding a tax penalty.
  7. 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.
  8. Taxes

    20 Tax Changes You Need To Know About

    Don't miss out on the tax changes. Here's a list that you need to know about.
  9. Taxes

    Who Does The Current Tax Code Benefit?

    Are the non-workers benefiting from the current tax code in any way or is it the wealthy who are still getting the big breaks?
  10. Retirement

    Who Pays Your Social Security Benefits?

    The short answer is, current earners. Taxes on current wages pay the Social Security benefits of retirees, the disabled, children and other beneficiaries.
Trading Center