Being your own boss, setting your own hours, enjoying the full fruits of your labor without interference —- that’s the self-employed dream!
The self-employment tax is a great example of one of the trade-offs that comes with working for yourself. If you get a regular paycheck from an employer, you will notice the deductions labeled “FICA – Social Security” and “FICA – Medicare” on your pay stub. FICA stands for the Federal Insurance Contributions Act, which requires every American worker to pay into the Social Security and Medicare trust funds in order to claim benefits upon retirement.
For 2015, the total cost of FICA contributions is 15.3% of earned income. If you work for someone else, your employer pays half of your FICA contributions (7.65%), and you are on the hook for the other half. If you are self-employed, however, you need to pay the entire 15.3% yourself. This is called self-employment tax.
Self-employment tax isn’t some kind of punishment for independent workers and small business owners. Its sole function is to make sure that self-employed people are covered by the same “safety net” insurance as salaried workers. By making FICA contributions on your earnings, you earn credits in the Social Security system, allowing you to claim a monthly benefit throughout retirement. The same is true for Medicare benefits. By paying self-employment tax, you are covered in your golden years.
Who Pays Self-employment Tax?
Self-employed workers generally fall in one of the following categories:
- A sole proprietor is a person who owns his or her own unincorporated business. A sole proprietor is self-employed, even if the business has other employees.
- An independent contractor owns and operates his or her own unincorporated business and is paid only for services rendered, not on a salary or wage basis. Independent contractors typically do work for other businesses.
- Members (owners) of Limited Liability Companies (LLCs).
- Members of an unincorporated partnership each qualify as self-employed, because profits from the shared business are “passed through” to their individual income taxes.
Keep in mind that you don’t have to be a full-time self-employed worker to qualify as self-employed. Many self-employed people operate home-based businesses in their spare time, or hire themselves out for part-time work in addition to holding down a “day job.” It does not matter whether you are full-time, part-time. If you made more than $400 in self-employment income, you are required to pay self-employment tax.
How to Calculate Self-employment Tax
The self-employment tax is calculated as a percentage of your net self-employment earnings. In 2015, the self-employment tax rate is 15.3 % of net earnings and consists of two parts:
- 12.4 % for Social Security
- 2.9 % for Medicare
Before you can figure your self-employment tax, you need to calculate your net self-employment earnings for the tax year which is generally the same as the net profit from self-employment. Net profit is the difference between gross income and all deductible business expenses. If your net profit is at least $400, you need to pay self-employment tax which is calculated as follows:
- Multiply the net profit amount by 92.35 percent (you are not taxed on your full earnings).
- For earnings less than $118,500, multiply the result by 15.3%.
- If you earned more than $118,500, multiply the amount by 2.9% then add $14,694 to the result. The tax code caps taxable Social Security earnings at $118,500, but Medicare taxes apply to all earnings.
For example, XYZ, LLC with net profit of $150,000 would pay $18,711 in self-employment taxes calculated as follows:
- 150,000 x 92.35% = $138,525
- $138,525 x 2.9% = $4,017
- $4,017 + $14,694 = $18, 711
Tune in to next month’s newsletter to find out your options for paying self-employment taxes