What Is the U.S. Self Employment Tax?
In the United States, the self-employment tax is a tax for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. This tax covers Social Security benefits and Medicare benefits. It ensures that self-employed individuals contribute to these federal programs like traditional employees.
Paying the self-employment tax is mandatory if net earnings from self-employment exceed $400. This tax consists of two parts:
- 12.4% goes to Social Security
- 2.9% is allocated to Medicare
Higher earners might pay an additional 0.9% in Medicare taxes on income exceeding certain thresholds.
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Who Is Subject to the Self-Employment Tax?
There are several types of workers that have to pay the self-employment tax.
Freelancers
Freelancers, who function as independent workers taking on projects from various clients, are subject to self-employment tax when their income surpasses the $400 threshold. Unlike employees, freelancers do not have their Social Security or Medicare taxes withheld by an employer. It is their responsibility to account for and pay these taxes through the self-employment tax.
Independent Contractors
Independent contractors are similar to freelancers but often work with fewer clients on a more regular basis. Like freelancers, they are responsible for their own Social Security and Medicare taxes, which are covered under self-employment tax. This is based on their net earnings from contracting work.
For independent contractors, understanding the distinction between being an employee and a contractor is important. Misclassification can lead to incorrect filing status and improper calculations of due taxes, potentially leading to penalties from the IRS.
Learn more in our detailed guide to Independent contractor misclassification
Gig Workers
Gig workers, participating in the gig economy through platforms like Uber or Airbnb, must also pay the self-employment tax if their income exceeds $400. These workers do not have an employer to withhold or pay Social Security and Medicare taxes on their behalf, making the self-employment tax their responsibility.
Gig workers should carefully track their income from each gig to ensure all earnings are accurately reported. Payments often vary by the number and type of gigs completed, so frequent monitoring and updating of records are necessary to maintain an accurate tally of annual earnings.
Online Sellers
Online sellers, including eCommerce store owners or individuals selling goods on platforms like eBay or Etsy, are subject to the self-employment tax when their net earnings surpass $400. These sellers are seen as self-employed by the IRS, and thus responsible for contributing to Social Security and Medicare through their tax payments.
Given the online nature of their business, maintaining detailed sales records and expenses is crucial. This includes keeping receipts, tracking inventory, and recording all transactions to accurately report earnings and calculate due taxes.
Self-Employment Tax Calculation
The self-employment tax owed by an individual can be calculated with this formula:
- First, determine your net earnings from self-employment, which means gross income minus allowable deductions.
- Then, multiply this net amount by 92.35% to account for an allowed deduction for the portion of self-employment tax paid.
- From this adjusted figure, calculate 15.3% to cover both the Social Security and Medicare charges.
- For earnings exceeding thresholds set by the IRS (see the table below), add the Medicare surtax of 0.9%.
These calculations contribute to your total tax liability for the year and must be accurate to avoid any discrepancies with the IRS.
Example of the Self-Employment Tax
For a clearer understanding, consider a freelancer with $50,000 in net earnings from self-employment in one year, and no allowed deductions. Here is how to calculate the self-employment tax:
- The initial self-employment tax calculation would involve reducing these earnings by 7.65% (to account for the employer portion of Social Security and Medicare), resulting in an adjusted income of $46,175.
- The self-employment tax on $46,175 would be 15.3%, equalling approximately $7,065. This amount includes both the Social Security and Medicare portions and represents the tax obligation due from the freelancer for these federal programs.
- In this example, the worker does not exceed any of the threshold amounts set by the IRS, so there is no additional amount for the Medicare surtax.
Tips for Managing the Self-Employment Tax
Here are some tips for self-employed individuals to manage their taxes.
1. Keep Accurate Records
Maintaining accurate financial records ensures you only pay the taxes you’re obligated to and can help in claiming permissible deductions. Use organized bookkeeping systems to track income, expenses, and tax information systematically.
By keeping meticulous records, you can manage your tax liabilities more effectively. This includes recording receipts, invoices, and expenses in a timely manner to prevent any miscalculations or misfilings during tax season.
2. Make Use of Deductions
Understanding and claiming appropriate tax deductions can significantly reduce taxable income and thus self-employment tax liabilities. Deductions such as business expenses, home office setups, travel costs, and health insurance can all lower the amount of tax due.
Ensuring you are well-versed in deductible expenses and making the most of them allows you to manage your tax burden efficiently. It reduces adjusted gross income and overall tax liabilities, easing financial pressures associated with self-employment.
3. Plan for Quarterly Payments
Self-employed individuals should plan to make estimated quarterly tax payments to avoid underpayment penalties. This involves dividing your estimated tax liability by four and making payments throughout the year, which helps manage larger sums by spreading the financial impact across several months.
Staying on top of these payments also ensures compliance with IRS requirements, reducing the chance of accruing interest or penalties due to late or insufficient payments. Regular reviews of earning patterns may necessitate adjustments in the amount set aside for upcoming quarters.
4. Utilize Tax Software or Professional Help
Navigating self-employment taxes can be complex. Utilizing tax preparation software or consulting a tax professional can help ensure accuracy in tax calculations and compliance with changing tax laws. These resources can offer guidance tailored to the specific needs of self-employed individuals.
By leveraging professional advice or automation tools, self-employed persons can reduce the risk of errors, maximize potential deductions, and maintain better financial and legal standing with tax authorities.
5. Stay Informed About Tax Laws
Staying updated with changes in tax laws is essential for anyone who is self-employed. Tax obligations can evolve due to legislative changes, which might directly affect tax rates, allowable deductions, and compliance requirements.
Regularly educating yourself about such changes, possibly through professional updates or reputable resources, ensures that your tax submissions remain accurate and beneficial, reflecting the most current regulations and maximizing compliance and efficiency in tax management.
Making it Easier on Your Business
Whether you’re an agency hiring dozens of freelancers, or an enterprise company with a handful, the chances are that freelancers are going to become an increasingly large slice of your strategy over the next few years. Understanding how freelancers pay taxes, as well as your own obligations isn’t something you can ignore.
Fiverr Enterprise is an end-to-end freelance management system (FMS) that gives you complete control over the hiring, payments, management and compliance processes of your freelance workforce. If you’re looking for a smarter way to manage freelancers, from tax and compliance through to milestones and payments – we should talk.