Contributed by: Tricia D, FreeTaxUSA Agent
Being self-employed can lead to a significant tax, as there is no employer to withhold taxes from your earnings. However, paying self-employment tax is important as it keeps you compliant with the IRS and supports your future benefits such as retirement income, disability benefits, and health insurance coverage. Understanding how self-employment tax works and making sure it’s paid properly will help you avoid penalties and manage your finances.
What is self-employment (SE) tax?
SE tax applies to individuals who are self-employed, contractors, or freelancers. It’s similar to Social Security and Medicare taxes withheld from the pay of most standard employees. It provides benefits you’re entitled to when you retire or in the event of a disability.
How is self-employment tax different from income tax?
SE tax is separate from income tax. Individuals who are self-employed are required to pay both.
- Income tax is based on your net taxable earnings, which is your total income after all eligible deductions and exemptions.
- It applies to income from wages, salaries, and other sources.
- It’s charged to business, corporation, partnership, and self-employed income.
- SE tax is imposed on your net profit from self-employment, which is your business income minus your business expenses. Use Schedule SE to figure out the tax, then put it on Schedule 2, line 4, and carry it over to your Form 1040, line 23.
Schedule 2, line 4 - self-employment tax:
Form 1040, line 23 – taxes including self-employment tax:
How is self-employment tax calculated?
Self-employment tax consists in two parts:
- Social security tax contributes to the Social Security program, which provides benefits for retirees, survivors, and individuals with disabilities.
- Medicare tax funds health coverage once you are eligible for Medicare.
SE tax adheres to specific limits and thresholds. The IRS may update the Social Security and Medicare tax rates. Consult this link for the most recent SE tax details. Here’s an overview of the essential information:
- Social Security tax is imposed on a portion of your net earnings from self-employment, up to the IRS limit.
- Medicare tax has no limit on the amount of earnings subject to tax.
- You might have to pay Additional Medicare tax if your earnings are above the IRS threshold for your filing status in the tax year.
In most cases, if you are employed and receive a W-2, your employer will contribute half of your Social Security and Medicare taxes. As a self-employed individual, you’re obligated to pay both the employer’s and the employee’s share of Social Security and Medicare taxes. Consequently, new business owners might be caught off guard by the SE tax when they submit their first tax return reporting business income.
SE tax is calculated based on the net income reported on Schedule C. FreeTaxUSA uses the information provided on the Business Income (Schedule C) screens to complete Schedule SE, which is then added to your tax return.
Do I need to pay SE tax?
You are required to pay SE tax under the following conditions:
- Net income from self-employment meets or exceeds the amount specified by the IRS annually.
- Your earnings from working for a church is equal to or more than the IRS minimum threshold.
This requirement applies regardless of age, even to those who are currently receiving Social Security or Medicare benefits.
You can deduct half of your SE tax, which helps to reduce your income tax. This deductible amount is calculated using Schedule SE and reported on Schedule 1 in Part II, line 15.
Schedule 1, line 15 – Deductible part of self-employment tax:
What is the impact of SE tax with multiple businesses?
When you own multiple businesses, your net income from each business is combined to figure your SE tax. A loss from one business can reduce profits from the other businesses.
Reporting multiple activities as separate businesses won’t reduce your SE tax liability. Even if one business brings in less income than the taxable limit, it’s the total earnings from self-employment that are relevant for SE tax calculations.
You need to be aware that the SE tax can apply to more than one person if you are filing a Married Filing Jointly return with business income in the name of both spouses. SE tax applies to each separate Social Security Number for the spouses based on the net income for each business or the net amount for each spouse.
Consider the following scenarios:
- You own two separate businesses: one brings in $250 from offering window-cleaning services, and another generates $2,000 via a ride-sharing service. Even though the window-cleaning profits are below the current $400 SE earnings threshold, the combined income from both activities totals $2,250, and is subject to SE tax.
- You operate a toy store that earns $60,000 in profits, and you also run a bookstore that incurs a $20,000 loss. Your net income from self-employment would amount to $40,000 after offsetting the profit and loss ($60,000 - $20,000).
