Self-employment tax is made up of Social Security and Medicare taxes that individuals who are self-employed pay on their net income. People who are not self-employed have Social Security and Medicare taxes withheld from their wages. People who are employees only pay half of these taxes. The employer pays the other half.
Employers and employees pay Medicare and Social Security as payroll taxes. For 2017 the Medicare tax rate is 1.45% for employers and employees. The Social Security tax rate for 2017 is 6.2% for employer and employees. Medicare and Social Security combined equals a 7.65% tax rate. An employer must pay 7.65% tax on any wages they pay, and an employee must pay 7.65% tax on any wages they earn. The social Security tax is only paid on the first $127,200 of the wages for each employee but there is no cap on Medicare. Employers withhold the employee’s portion of these taxes from the employee’s pay check. At least once a quarter the employer must pay the company’s portion and the employee’s portion to the government.
If you are self-employed, the IRS considers you the employer and the employee, so you must pay the employer and the employee’s portion of the payroll taxes. Adding the employer tax rate of 7.65% and the employee tax rate of 7.65% equals 15.3%. Self-employed people must pay a tax rate of 15.3% on the net income they earn. The IRS does give you one break. You get to deduct the employer “half” of the self-employment tax.
To calculate your self-employment tax, first you need to calculate your net income from your self-employment business. You get to deduct half of the self-employment tax, so you need to calculate your “net self-employment income”. To do this you multiply your net income by .9235. Multiply the result by .153 to get your self-employment tax. Here is an example:
NET INCOME OF $50,000 x 0.9235 = $46,175 x 0.153 = $7,064.78
The self-employment tax on $50,000 in net income equals $7,064.78 or $588.73 a month, assuming this is for a calendar year.
You are only required to pay Social Security tax on the first $127,200 of your income from wages and self-employment. If you are an employee for a company that issues you a W-2, you are paying Social Security tax through your withholding. If your salary is $100,000 and your net income from your business is $50,000, your total earned income equals $150,000. You would have paid $6,200 in social security tax at the 6.2% employee rate on your $100,000 salary. Only $27,200 of your $50,000 will be subject to Social Security tax. Medicare tax will be due on the entire $50,000.
Self-Employment tax is reported using Schedule SE (Form 1040). Schedule SE is filed as part of your 1040 form. You do not file Schedule SE by itself. You can pay your self-employment tax with your 1040. However, if you owe a lot of tax you will incur a penalty and interest charge. If you think that you will have a substantial net income from self-employment, you should make estimated tax payments.
The IRS has a general rule stating that you must pay estimated tax if you expect to owe at least $1,000 in tax and you expect your withholding and credits to be less than the smaller of: 90% of your tax due or 100% of your prior year tax. The easiest way to estimate your tax is to use last year’s tax return. Estimated tax payments are due in April, June, September, and January of the following year. Divide last year’s tax by 4 and send that amount in each quarter. Usually this is enough to avoid any real penalty. If you think that you will have more net income than the prior year, you can use the calculation sheet on form 1040-ES. Form 1040-ES also has a form to calculate your self-employment tax.
You can also calculate your self-employment tax each quarter using the formula above or the form on form 1040-ES. If you are keeping up with your bookkeeping it won’t take much time to calculate your tax to make sure you don’t incur a penalty by estimating too low.
Self-employment tax seems complicated, but I think it’s straight forward once you understand what it is and how its calculated. If you are still not sure how to calculate and pay it, talk to a CPA. You don’t want to get into trouble with the IRS because you made a mistake. The IRS has a way of making mistakes cost a lot.