The word ‘tax’ doesn't exactly bring up happy thoughts. So much so, that many are even scared of the tax declaration season every year. Especially when it comes to the Self-Employment Tax, the effect is undoubtedly much greater!
But contrary to popular belief, the self-employment tax comes with an enormous number of benefits and ensures future security. This article will clear all your doubts about Self-Employment tax.
We will discuss:
- What is Self Employment Tax?
- What is the Self-Employment Tax Rate for 2020?
- Self-Employment Tax Breakdown
- Who must pay Self-Employment Tax?
- Family, Caregivers, and Special SE Tax Rules
- Information Required to Pay Self-Employment Tax
- Self-Employment Tax Deduction
- What are the Self-Employment Tax Deductibles
- How to Calculate Self-Employment Tax
- Corona Consideration
What is Self Employment Tax?
The self-employment tax (SE tax) is a tax collected from small business owners to fund their Medicare and Social Security. It is imposed by the federal government. This tax is a basic tax and not optional. It applies to individuals with a net earning of $400 or more through self-employed means over a financial year. A self-employed person making less than $400 does not require to pay any kind of employment tax. They are exempted from this obligation. Like other taxes, self-employment tax is also reported by the IRS. You will need to submit Form 1040 Schedule SE. While filing your returns, make sure you complete this form and attach the supporting documents with it. When you use TaxSlayer or E-file.com they check for all common errors before submission. They make tax filing super easy for you.
In general, both the employee and the employer share the contribution towards two major social welfare programs – Social Security and Medicare. When you’re self-employed though – you’re your own boss and employee. This means you get to pay for both sides.
If you’re self-employed, you can deduct the employer-equivalent portion of your SE tax while figuring your adjusted gross income (AGI). Wage earners do not enjoy this liberty.
What is the Self-Employment Tax Rate for 2020?
Self-employment tax typically encompasses Social Security and Medicare. There may be other taxes also which one needs to pay, but that doesn’t count under SE tax. The self-employment tax rate is 15.3%. In 2019, the first $132,900 of the earnings were subject to this tax.
The amount, however, has increased to $137,700 in 2020. This limit is known as the maximum wage base, and anything above this limit is exempt from the Social Security part of the SE tax. It means you do not have to pay Social Security on your earnings over $137,700 for the 2020 tax year. The maximum wage base tends to increase every year to match the inflation rate.
Self-Employment Tax Breakdown
The 15.3% SE tax is a combined sum of two components – 12.4% Social Security tax and 2.9% Medicare, also known as ‘Health Insurance Tax’.
The official name of Social Security is OASDI – the federal Old-Age, Survivors, and Disability Insurance. As the name suggests, Social Security funds old age, survivor, disability, widow/widower benefits for older Americans. It also helps look after individuals, children in critical conditions. By paying Social Security tax when you’re employed, you gain Social Security credits for the future. For the wage earners, the Social Security tax is assessed at a rate of 6.2% from the employer and another 6.2% from the employee. This is an effective way of collecting 12.4% (6.2% + 6.2%) Social Security tax without putting much burden on the employees' paycheck. As mentioned earlier, the maximum wage base applies only in the case of Social Security and it is $137,700 for the 2020 tax year.
The second component of the SE tax – Medicare tax rate is 2.9%. Please note that the Social Security component of the SE tax applies until the net income reaches the maximum wage base, but that is not the case with the Medicare tax. The Medicare tax must be paid under all circumstances. In fact, an additional 0.9% Medicare tax levies on earnings above $200,000, if you’re single, and $250,00 if you’re filing jointly. Self-employed individuals should pay their Medicare taxes so as to receive health insurance benefits upon retirement.
Who Must Pay Self-Employment Tax?
SE tax is a mandatory tax paid by the workers or entrepreneurs who work for themselves. For example, sole proprietors of various start-ups, freelancers (who work for multiple clients and are not tied to any institution in particular), independent contractors. As per the IRS, even if you are a profit-sharing business partner who doesn't involve in the first-hand trade, you’re to be considered as ‘self-employed’. Simply put, individuals coming under either of the given categories or both, are required to file SE tax as per Schedule SE (Form 1040 or 1040-SR) –
- You have net earnings of $400 or more from self-employment means (excluding church employee income).
- You have a church employee income of $108.28 or more.
Before filing your tax returns, you would first need to figure out your net income subject to self-employment tax. Say, if you are the sole proprietor of your business and you want to calculate your net earnings from the self-employment sources – how would you do that? Simple, just refer to Schedule C.
If you have earnings subject to self-employment tax (i.e, $400 or more), use Schedule SE to figure your net earnings that qualify for self-employment tax.
Fact: The self-employment tax rules apply to everyone. It does not depend on your age. Even if you are receiving Social Security or Medicare, you are required to pay the Self-employment tax.
Family Caregivers and Special SE Tax Rules
The Family Caregivers come under the special rules of Self-Employment Tax. Caregivers are individuals employed to provide services to the elderly or disabled individuals who can not live on their own. If your self-employment income is coming from a source like this (caregiving services), conventional SE tax rules won’t apply to your income. In that case, refer to Family Caregivers and Self-Employment Tax page and Publication 926 on the IRS website.
Information Required to pay Self-Employment Tax
Paying self-employment tax is no different from paying other taxes. For this, you require a Social Security number (SSN) or an Individual Taxpayer Identification Number (ITIN). Yes, that's the same, too!
● If you don’t have your Social Security Number (SSN) yet, here’s how you can get one –
Apply for SSN using Form SS-5. It is the application for receiving a Social Security Card. You can get this form at your nearby Social Security office or by calling up (800) 772-1213, or you can just download it from the official IRS site.
● If you qualify for Individual Taxpayer Identification Number (ITIN) and not SSN, here’s how you can obtain ITIN –
Going by the rules, the IRS will issue you an ITIN if you are a non-resident or a resident alien, and you are not eligible to get an SSN. To apply for an ITIN, you should file Form W-7.
● If you’re paying Self-Employment Tax with Estimated Taxes
If you are self-employed, you will be expected to file Estimated Taxes quarterly. You can always refer to the official IRS website for details on this. Alternatively, you can hire any of the firms mentioned in this article to avoid the hassle altogether.
Deducting the employer-equivalent portion of your SE tax would not affect your income tax. It only affects the net earnings from self-employment or your self-employment tax. However, if you file a Form 1040 or 1040-SR Schedule C, you might be able to claim the Earned Income Tax Credit (EITC).
What are the Self-Employment tax deductibles
You get to enjoy a lot more when you’re self-employed than just being your own boss and working at your own time.
Here’s a quick rundown of the tax deductions you are eligible for when you are minding your own money –
- SE Tax – Employer portion of SE tax or, 7.65% (15.3% / 2) of SE tax can be adjusted in AGI. The IRS considers the ‘employer’ portion of your SE tax as a business expense and allows you to deduct it accordingly. This means you are required to pay SE tax on 92.35% (100% -7.65%) of your net earnings.
- Home office- Expense on your home office can be written off.
- Vehicle use- The day-to-day maintenance cost for the vehicle you are using to carry off your business activities can be waived off.
- Meals – Meals during the office hours or meeting with the clients are also added under business expenses.
- Internet and phone bills – Charges to communicate with the clients are considered as an expense.
- Health insurance and premiums – Expense for your health covers can be waived off.
- Travel – Travel during the course of business is one of the major deductions allowed.
- Business insurance – If you have business insurance, then it is also taken into account.
- Interest – Interest on any kind of business loan is a tax-deductible business expense.
- Publications and Subscriptions – Costs of journals, magazines related to your business can be deducted.
- Education – Courses taken to improve business skills are considered a tax-deductible expense.
- Rent – Rented out office spaces is a major expense. And the good part is, it’s tax-deductible.
- Capital – The IRS allows you to deduct your business set up cost but over time. One time deduction of $5000 is permitted.
- Advertising – By the rules, any kind of online and offline promotion of your business is tax-deductible.
- Retirement Plan – Investment in retirement plans is very important and helps with tax deductions as well.
LibertyTax can help you file your return without a hassle. It offers an easy-to-use, browser-based tax filing system that reduces the chances of error to zero percent.
How to Calculate Self-Employment Tax
Let’s suppose you are a freelance marketer with a gross income of $270,000 in 2020. Your business expenses account for $70,000, and you’re a single filer. Then, how much SE tax would you expect to pay?
Net income = Gross – Expenses
= $270,000 – 70,000
Your SE tax will be 92.35% of your net i.e, 92.35% x $200,000 = $184,700
The max wage base for 2020 is $137,700.
So, you will pay 15.3% of $137,700 = $21,068.1.
Since you’re self-employed, you can claim an above-the-line deduction (employer portion of SE tax), or $21,068 ÷ 2 = $10,534.05. This means you are getting a refund on the employer portion (6.2% Social Security + 1.45% Medicare = 7.65%) of your self-employment tax.
The CARES (Coronavirus Aid, Relief, and Economic Security) Act, signed into law by President Trump on March 27, 2020, deferred payment of the employer portion of self-employment taxes (which goes to Social Security) for the period of March 27, 2020, through Dec. 31, 2020. The act deferred 50% payment of those taxes until Dec. 31, 2021, and the other 50% until Dec. 31, 2022.
Self-employment tax is the government's way of making sure that the self-employed individuals are making similar contributions to the health of the federal economy, and in return, receiving the same benefits as salaried individuals. These taxes help at the times of national contingencies. The percentage of 15.3% may look fat for those who have recently started out on their own, but after a while, they will definitely get to reap its benefits. Moreover, through the various tax deductions available, individuals can save a lot.
If you are self-employed, you do not have a tax deduction at the source. You don’t have your payslips! So, you got to be prepared to do all the groundwork by yourself. You can always seek professional help to do your taxes. FreeTaxUSA, H&R Block, Tax Group Center, LibertyTax, TaxAct, and E-file.com are some services that you can consider. Within a few mins, they help you e-file your federal and state income taxes with 100% accuracy.
Paying SE tax is important, and it comes back to you in the hour of need.