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This story originally appeared on MarketBeat
I recently became self-employed. (Yes, by choice, not by necessity, though maybe many would question my judgment.)
Like me, have you also just made this hold-onto-your-shorts leap? If so, you probably want to know as much as you can about self-employment tax. (And resist my initial urge to take a snooze — if you can.)
Let’s go over the basics, though it’s a great idea to buddy up to your accountant so you understand your complete tax picture and what self-employment tax means for you. At any rate, understanding self-employment tax will get you ready for estimating your quarterly taxes in June.
Definition of Self-Employment Tax
Seems pretty straightforward, right? Self-employment tax involves taxes that you have to pay as a self-employed individual.
It’s a little bit deeper than that, as you might imagine. Individuals who work for themselves must pay Social Security and Medicare taxes just like you would if you worked for an employer. This ends up working out a lot like when Social Security and Medicare taxes get withheld from the pay of most wage earners.
Furthermore, who fits into the self-employed category? The IRS puts you in this category if you work at a trade or business as a sole proprietor or an independent contractor. You also go into this category as a member of a partnership or you are in business for yourself, and this includes a part-time business.
What is the Self-Employment Tax Rate?
Put succinctly, the self-employment tax rate amounts to 15.3%. This equates to a total broken down percentage of 12.4% for Social Security and 2.9% for Medicare taxes.
Seems terribly high, doesn’t it? Yes, it might seem that way, especially if you’re scraping for every penny as an independent contractor. However, focus on the positive: You only pay self-employment tax on net earnings.
What does that mean? This means that first, you get to subtract any deductions, such as business expenses, from your gross earnings. In addition, you can claim 50% of what you pay in self-employment tax as an income tax deduction. For example, let’s say you pay $2,000 in self-employment tax. This payment reduces your taxable income by $1,000 and can save you a lot of money on your income taxes.
How to File Self-Employment Taxes
Take these steps to file self-employment taxes every year.
Step 1: Pay taxes quarterly.
As a self-employed individual, the IRS recommends that you file an annual return and pay estimated tax quarterly.
Step 2: Know your forms.
You determine your self-employment tax (SE tax) using Schedule SE (Form 1040 or 1040-SR). If you’ve had a job in the past, you know that your employer would determine your Social Security and Medicare taxes of most wage earners, so you may never have had to do this before.
You may have to fill out other self-employment tax forms as well as the Schedule C or Schedule C-EZ to report any income or loss.
Step 3: Calculate your income and expenses.
Your income and expenses involve understanding how much you’ve made. This requires careful addition. You also want to total up your expenses — the amount of money you’ve spent in your business. You may serve as a contractor and fill out 1099 forms for each company you work for, but other individuals you work with may just accept invoices from you.
Step 4: Determine whether you need to fill out an information return.
Self-employed individuals or small businesses who make payments may have to file an information return. However, you may want to take a look at the qualifying information for these items, which are very specific. Information returns include payments like services performed by independent contractors, prizes and awards, rent, royalties, backup withholding, crewmembers of your fishing boat (see how specific it is?), to physicians, for a purchase of fish from anyone engaged in the trade or business of catching fish, crop insurance proceeds and others.
Information returns may also include interest on business debt, dividends to a company shareholder, distribution from a retirement plan or payments to merchants like third-party network transactions.
As far as payments go, it may concern mortgage interest, sale of real estate, covered securities, releasing someone from paying a debt and direct sales of consumer products.
Step 5: Consult an accountant.
You can also bypass all the other steps and skip right to this step. You may feel daunted already by the myriad types of forms and deduction options and you might want to either have your accountant tackle all of it for you or have him or her take a look at your prepared documents before you submit them for quarterly taxes.
Ways to Save on Taxes
You want to become hyper-alert to every single thing you pay for that allows for a write-off of your taxes.
- Startup costs: Whatever you need to start your business, whether it’s securing premises, marketing, advertising or hiring a copyright attorney — whatever it is, you should be able to deduct it.
- Mileage: When you travel for your work, you can deduct the mileage you travel as well as vehicle expenses, such as, for example, a new backup camera you got for delivering items for your business.
- Home office: Don’t forget to deduct the square footage of your home office if you spend time in that room doing work.
- Supplies and equipment: Did you buy a new laptop? A printer? Computer paper? You can deduct every little thing you buy for your home office. Keep your receipts!
Your accountant (or a good tax software that you use throughout the year) can help you identify deductions as they come across your desk. It can also save your information from year to year so you can easily identify items that you can deduct every year.
Get Educated About Self-Employment Taxes
The more you know about your taxes as a self-employed person, the more you will realize how much you have to learn about self-employment taxes. (I know I feel that way!)
The tax rules apply to you even if you receive Social Security or are on Medicare, so it’s worth learning them now for the long term.
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