What is Self-Employment Tax?
Furloughs and layoffs, although unfortunate, happen quite often within any industry causing an unexpected career change. Covid has brought an unexpected career change for a lot of people throughout the past few months due to furloughs and layoffs. It’s forced us all to ‘think outside the box’ and tap into our entrepreneurial toolbox. Creating additional streams of income quickly became the norm to sustain income, but with the spike in freelance and contract work comes the steep learning curve about self-employment tax. If this is you, first off, pat yourself on the back for the courageous career choice! While it’s usually the idea of working for yourself, diversifying your income and controlling your schedule and workload that get you going about being self-employed, it’s usually the fear of the unknown that holds a lot of people back from self-employment - and by fear, I’m referring to the monetary fear of how to pay yourself and how taxes work.
Sole proprietors, freelancers, contractors, single-member LLCs and general partners in partnerships are all considered self-employed unless they elect some other form of taxation. So what does that mean? You’re in business for yourself and are not an employee of a company where you’re paid via payroll and the employer withholds taxes based on your W-4. But that doesn’t mean the money you earn is free and clear of taxes - one can only dream, right?! . You are responsible for self-employment taxes.
Social Security and Medicare taxes are federal taxes. One of the biggest differences between self-employment tax and payroll taxes associated with W-2 pay from a regular job is that employers typically pay half of these taxes for you (i.e., you pay 7.65% and your employer pays 7.65%) and this happens automatically through your payroll deductions. Easy! When you’re self-employed, you’re kind of like the employer and the employee. That means you’re responsible for both halves of the tax. The self-employment tax rate is 15.3% of your net earnings (or profits). This breaks down to 12.4% towards Social Security (up to a certain threshold) and 2.9% for Medicare (on all net earnings with no threshold). These taxes are in addition to federal income tax and any state income taxes. At just $400 of net earnings (income after expenses), you’re subject to self-employment taxes. This usually creates a pretty shocking tax bill for a new entrepreneur, especially if you’ve gotten accustomed to having taxes withheld on your behalf at an employer. So how do you prepare for it? Keep good books and records (yes, we offer bookkeeping services!), and touch base with your CPA (like ASE Group) to determine your tax payments and when you need to pay them. Federal estimated tax due dates can be found here.
How to Estimate Your Self-Employment Taxes
Consulting with a CPA is the best and most accurate way to determine the amount you owe in self-employment taxes (and other income taxes) and how frequently you need to make payments (quarterly or annually.) You can also use the IRS Estimated Tax Worksheet to estimate your self-employment taxes. To calculate how much money you should be saving, try these helpful tips:
Calculate your gross earnings for the year or determine your monthly average to anticipate your year-end earnings.
Deduct your business expenses like supplies, software, advertising, phone/fax services, and let’s not forget processing fees from credit card or bank payments.
Once you have that net figure, generally 92.35% of that total is subject to self-employment tax.
Apply the 15.3% self-employment tax rate.
On a side note, only the first $137,700 of your net earnings are subject to the Social Security self-employment tax portion (for the 2020 tax year)
Is your head spinning? If so, take a breather. At ASE Group, we take the guesswork out of your tax planning and preparation. We’ll help you get your bookkeeping in order so that we can estimate your taxes and identify tax-saving opportunities. (Look out for our next blog post for more tips on maximizing your deductions.) We can help you set up your finances to anticipate quarterly tax payments and keep you and your business in good standing with the IRS and state tax authorities
Want to discuss how we can help you?