Money Girl explains what the self-employment tax is, who must pay it, and how to comply with the tax law when you work for yourself.
Working for yourself, either as a part-time side hustle or a full-time endeavor, can be very exciting and financially rewarding. But there’s a downside: There are special tax rules you must follow in order to stay out of trouble when you’re self-employed.
In this episode we’ll cover what the self-employment tax is, who must pay it, and how to comply with the tax law when you work for yourself. I’ll also give you resources to cut through the confusion of becoming your own boss.
What Is Self-Employment Tax?
When you work for someone else, no matter if it’s a small business or a huge corporation, your employer picks up the tab for some of your taxes. Thanks to the Federal Insurance Contributions Act (FICA), employers are generally required to withhold Social Security and Medicare taxes from your paycheck and to match the tax amounts you owe.
That means your employer pays half of your Social Security and Medicare taxes and you pay the remaining 50% as a deduction from your paycheck. This is in addition to federal and state taxes that are also withheld from your wages and sent to the government each pay period.
But when you’re self-employed, you are the worker and the employer, so you have to pay all your taxes. Therefore, in addition to federal and state income taxes, you must pay the self-employment (SE) tax, which is 100% of Social Security and Medicare.
See also: From Employee to Self-Employed
You’ve got to pay the SE tax no matter if you call yourself a sole proprietor, partner, independent contractor, or freelancer. When you boil it down, these distinctions simply mean that you’re a small business owner and have more tax responsibility. And these rules apply no matter your age or if you're already receiving Social Security or Medicare benefits.
What Is the Self-Employment Tax Rate?
For 2014, the self-employment tax rate is 15.3%. It applies to the first $117,000 of your net income, plus 2.9% on net income over that amount. Here’s how the rate breaks down:
- Employee’s portion of Social Security tax: 6.2% of the first $117,000 of net income
- Employer’s portion of Social Security tax: 6.2% of the first $117,000 of net income
- Employee’s portion of Medicare tax: 1.45% of all net income (there is no cap)
- Employer’s portion of Medicare tax: 1.45% of all net income (there is no cap)
In other words, if you’re self-employed with net income less than $117,000, you must pay FICA tax of 15.3% (12.4% Social Security plus 2.9% Medicare tax), plus federal and state income tax.
What Is the Additional Medicare Tax?
Additionally, there’s a brand new tax for high earners called the Additional Medicare Tax. It went into effect in 2013 as part of the Affordable Care Act (ACA), also known as Obamacare.
This surtax is 0.9% and applies to wages and self-employment income over certain amounts. Here are the income thresholds by tax filing status for 2014:
- Single: $200,000
- Head of household: $200,000
- Qualifying widow(er): $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
You must pay estimated tax based on how much you think you’ll earn—even if you’re just working part-time at your business.
What Is Estimated Tax?
When you’re self-employed, you generally must pay estimated taxes in advance of every quarter. Paying estimated taxes helps you stay on top of your liability throughout the year for income that is not subject to tax withholding. Otherwise, you might come up short on tax day.
You must pay estimated tax based on how much you think you’ll earn—even if you’re just working part-time at your business. This includes federal and state income tax and the self-employment tax.
If you underestimate what you’ll earn and don’t pay enough though estimated tax payments, you may be charged a penalty. But if you overestimate earnings and overpay, you’ll be eligible for a tax refund after you file taxes.
See also: Taking Home Office Deductions