Understanding Self-Employment Tax

Since I started my tax practice seven years ago, I have found myself spending a lot of time helping business owners understand what self-employment tax is. As a sole proprietor myself, I know all too well the pain of writing those big checks to cover my taxes. But re-framing my way of thinking about the tax has been helpful, and that’s what I will attempt to do for you today. I’ll explain what you’re “buying” with self-employment taxes, and how to understand how the amount due is calculated. In a follow-up article, I will suggest some ways to plan to have the money available when it’s time to pay your self-employment taxes. In this article, I’m going to focus on U.S. federal taxes for a sole proprietor. Each state has slightly different tax rules, but generally, the big tax for self-employed people comes at the federal level.

First, I need to define a couple of terms. In our minds, we tend to lump “taxes” all together, but it’s important to realize there are different taxes we pay on our income, and each tax goes to different things:

  • Self-Employment Tax (SE tax) is a very specific investment into Social Security and Medicare. When you pay your SE taxes, you are buying credits in your future ability to receive Social Security and Medicare benefits.
  • Income Tax is the tax levied on your total personal income. The money raised by income taxes goes toward all the rest of the programs of the government. I tell my clients that this is each of us paying our fair shares of schools, roads, and defense—all those things we’ve come to expect our government to provide.

When talking to self-employed people, I like to tell my clients there is good news, bad news, and then good news.

I start with the good news: you are self-employed; you get to be your own boss! You get to choose the jobs you’re willing to work and the jobs you are NOT willing to take on. You get to set your own hours for when you’re going to do the work. You get to set the environment you’re going to work in. You set your own prices for what you want to be paid. All of these are wonderful, “good news” things that are really inspiring arguments for self-employment.

Understanding possible “bad news” requires a little explanation. When you are working as an employee for someone else, every time you receive a paycheck, there are taxes withheld. In addition to federal and state income tax, your employer withholds 6.2% of the gross pay for Social Security and 1.45% of the gross pay for Medicare. Before your employer sends the money into the IRS for your Social Security and Medicare credits, they match your contribution. The employer pays an additional 6.2% of gross wages for Social Security plus 1.45% of total wages for Medicare. Think about it this way: for every hundred dollars you earn from an employer, $15.30 is sent to Social Security and Medicare on your behalf; of this $7.65 total was withheld from your paycheck and $7.65 was extra money paid by your employer.

When you are self-employed, remember that you get to be your own boss! BUT something to realize is that part of being your own boss is that you have to pay BOTH halves of Social Security and Medicare taxes. That’s 12.4% for Social Security plus 2.9% for Medicare. On $100 of income, you have to pay out $15.30 in SE taxes. Also, unlike working for an employer where they automatically withhold money from your paychecks, you’re the one who has to do the withholding from your earnings because you are the one responsible for sending in the money. Generally, the payment is submitted as quarterly estimated tax payments.

I told you at the beginning that there was good news, bad news, and then good news for self-employed people. Paying both halves of the Social Security and Medicare taxes qualifies as “bad news.” But here’s the remaining good news… before you figure out how much SE tax you have to pay – you get the opportunity to deduct business expenses from your gross income. If you’re selling a physical product, you certainly deduct the materials that went into producing the product—this is known as your cost of goods.

There are additional deductible expenses over and above the cost of goods that can be used to reduce the overall income you are paying taxes on. Some expenses for this audience might include software fees, office rent, office supplies, continuing education, dues and memberships (like Being Boss Clubhouse fees paid), credit card processing fees, postage or shipping, internet connection, etc. The reason why we tax preparers want ALL the nitty gritty expense details from you at tax time is to try and reduce the amount of SE taxes you will otherwise be paying.

In conclusion, the important thing to understand is that the bulk of self-employment tax is buying your personal credits in Social Security and Medicare. Some would question if these programs will be around when it is your turn to collect it. That’s really a conversation for another day – you still have to pay the taxes, regardless of your political concerns. And your credits in the system are tracked and accounted to you. Our society would have way bigger problems than we experienced in with the 2008 housing market explosion and subsequent recession if it were to get rid of Social Security. For me personally, I rest assured that my retirement will have supplemental income from Social Security and I appreciate that the money I’m paying in now is coming back to my parents in their monthly benefits.

Keep your eyes out for a follow-up post next month where I’ll be talking about strategies for paying self-employment taxes.

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Jessica McKnight
Jessica is a tax preparer in Arcata, California. She worked in retirement planning and financial advising before becoming a tax preparer in 2010. She is passionate about helping her clients understand how to plan through all of the transitions and changes of life.
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