The Self-Employment tax (SE) refers to the taxes that self-employed individuals pay toward Social Security and Medicare. At a rate of 15.3 percent, it’s hard not to notice on your tax bill. The self-employment tax is the self-employed version of FICA (Federal Insurance Contributions Act) paid by employees and employers toward social security and Medicare. Under FICA, employees and employers share the burden of these taxes, but as a self-employed individual you are responsible for the full amount. However, all is not lost; there are potential tax credits and ways to save.
Your self-employed income has a 15.3 percent tax rate on the first $117,000 of your SE income. Of that 15.3 percent, 12.4 percent is for Social Security tax, and 2.9 percent is for Medicare tax. Any income that exceeds the $117,000 cap for social security taxes will still incur the 2.9 percent Medicare tax. Once your self-employed income reaches certain thresholds based on filing status, ($200,000 for an unmarried individual, or $250,000 if married and filing jointly), you will be required to the pay 0.9 percent for the Additional Medicare Tax.
In order to determine the amount you will owe for your SE taxes, you must first calculate your SE income. Generally the amount of your net earnings subject to this tax is 92.35 percent, which you would multiply against your bottom line. That number is your SE income. Self-employment tax is computed on Form 1040, Schedule SE, and you report that amount in the “Other Taxes” section.
You can deduct 50 percent (essentially the employer-equivalent portion) of your SE tax bill on your income tax deduction. This deduction is available whether or not you itemize deductions and claim deductions on Form 1040. If you run a small business but also have a job that has social security tax taken out of your paycheck, you will get credit for that on your Schedule SE tax form. However, you will still have to pay the 2.9 percent SE tax rate for the Medicare tax on your entire SE income. Self-employed individuals are also able to deduct the cost of health insurance from their SE net earning; use Form 1040 and Schedule SE instructions for calculating and claiming the deduction.
There are many saving options available for the self-employed, among them Simplified Employee Pension (SEP) IRA, Simple IRA and individual 401(k) plans. They all offer tax breaks and tax-deferred savings.
- Simplified Employee Pension: With the SEP IRA, paperwork is at a minimum and set up is easy. You can put away as much as 25 percent of your net income and have the flexibility to wait to fund the plan until you file taxes. As with SIMPLE IRAs, an employer would have to make a contribution on behalf of employees.
- SIMPLE IRA: The Savings Incentive Match Plan for Employees (SIMPLE) IRA allows you to keep investing in the same plan once you hire someone, but you are required to match your employees’ contributions (up to 3 percent of pay). This plan only allows you to save up to $12,000 (plus an additional $2,500 if you're 50 or older) and you could face significant fees (15 percent higher than a SEP IRA) if you decided to withdraw money early from the plan. However, sole proprietors who decide to transition and hire full-time employees can do so more easily with the SIMPLE IRA.
- Individual 401(k): The individual 401(k) allows you to make salary deferrals of up to $17,500 (plus an additional $5,500 if you’re 50 or older). You can contribute an additional 25 percent of your net earnings from self-employment (up to $52,000 for 2014), including salary deferrals. You can also tailor the individual 401(k) plan to allow you take out a loan against it, should you face hardship in your business.
The SE tax can be substantial, but you also have a considerable amount of deductions in your favor. There are many saving options available for the self-employed, and it’s crucial to find the right fit for you and your company, whether you’re a sole proprietor or a growing small business. Making smart tax decisions and tax-efficient investments can add up considerably over time.