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Self-Employment Tax Explained: How It Works, Rates, and Case Study Examples

Last updated 03/14/2024 by

Alessandra Nicole

Edited by

Fact checked by

Self-employment tax is a mandatory payment imposed on self-employed individuals and small business owners, contributing to Medicare and Social Security funding. This tax applies when an individual’s net earnings surpass a specified threshold or when earning over $108.28 from a tax-exempt church. Reporting is done on IRS Form 1040 Schedule SE, with exemptions for those falling below the earning thresholds.

What is the self-employment tax?

Understanding self-employment tax

Self-employment tax refers to the obligatory tax individuals working for themselves must pay. It funds vital federal programs like Medicare and Social Security and serves as a substitute for the employer’s share of the Federal Insurance Contributions Act (FICA) tax.

Who needs to pay?

Individuals with net earnings surpassing $400 or $108.28 from a tax-exempt church during a tax year are subject to pay the self-employment tax.

Reporting and exemptions

This tax is calculated and reported on IRS Form 1040 Schedule SE. However, individuals earning below the specified thresholds are exempt from paying this tax.

How the self-employment tax works

Qualifying as self-employed

Those deemed self-employed encompass sole proprietors, freelancers, independent contractors, and members of a trade or business partnership.

Tax calculation

Self-employed individuals must pay self-employment tax to receive Social Security benefits upon retirement. They are responsible for both the employer and employee shares of Social Security and Medicare taxes.

Self-employment tax rates

Social security and medicare taxes

The Social Security tax stands at 12.4%, as the self-employed individual is viewed as both employer and employee. Medicare tax is set at 2.9%, without an income limit.

Tax deductions

Although self-employment tax is based on business profits, there’s a deduction available for the employer’s half (7.65%) when calculating income tax.

Special considerations

Estimated tax payments

Self-employed individuals are required to make quarterly estimated tax payments for federal and state income taxes, as well as FICA taxes.

CARES Act and additional tax

The CARES Act deferred a portion of self-employment taxes. Additionally, high-income earners face an additional 0.9% Medicare tax due to the Affordable Care Act (ACA).

Example of the self-employment tax

Calculation and deductions

Typically, individuals pay self-employment tax on 92.35% of their net earnings. A practical demonstration will help in understanding the tax liabilities and deductions for a hypothetical business owner.

How do I pay my FICA tax if I’m self-employed?

Reporting FICA taxes

Self-employed individuals report their FICA taxes on IRS Form 1040 Schedule SE, acting as both the employer and the employee.

Side gig and social security tax

Any side income exceeding $400 a year necessitates Social Security and Medicare taxes, similar to regular employment.

Changes in FICA taxes

Insights into the historical stability of the Social Security tax rate and the Medicare tax rate changes related to the ACA.
Here is a list of the benefits and the drawbacks to consider.
  • Contributing to Social Security and Medicare benefits for retirement
  • Availability of tax deductions on the employer portion
  • Quarterly estimated tax payments might be burdensome for some individuals
  • Additional tax burdens for high-income earners

Frequently asked questions

Who needs to pay self-employment tax?

Individuals with net earnings exceeding $400 or $108.28 from a tax-exempt church are obligated to pay self-employment tax.

Are there exemptions from self-employment tax?

Those who earn less than the specified thresholds are exempt from paying self-employment tax.

How is the self-employment tax calculated?

Self-employment tax comprises both the employer and employee shares of Social Security and Medicare taxes.

Key takeaways

  • Self-employment tax is essential for self-employed individuals to contribute to Social Security and Medicare.
  • Quarterly estimated tax payments are crucial to fulfill tax obligations for self-employed individuals.
  • High-income earners face additional tax burdens due to self-employment tax.

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