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The Essential Guide to Self-Employed Pay

Sharissa Barnett Aug 4, 2023 12:23:15 PM
taxes sign with US dollars

What Taxes Do The Self-Employed Pay?

If you intend to become self-employed in the US, you may have been asking yourself a few questions: What taxes do the self-employed pay, or what tax do you pay when self-employed? Do you pay more taxes if you are self-employed? What is self-employment tax? What do you pay tax on when self-employed?

What does a self-employed person need to file taxes? What rate of tax do the self-employed pay? How much should I set aside for taxes if self-employed? What is the 20% self-employment deduction? etc.

By the time you are through reading this post, the answers to these questions will be a lot clearer. But before answering what taxes do the self-employed pay or what taxes do you pay if you are self-employed? and the other questions, it is necessary to first define some key terms.

Who Is Self-Employed?

According to the United States Internal Revenue Service (IRS), a person is considered self-employed if any of three conditions apply to him or her. The first condition is if you are involved in a trade or business as a sole proprietor or an independent contractor. The second is if you are a member of a partnership involved in a trade or business, while the third is if you work for yourself (e.g. as a part-time businessperson, freelancer, or a gig worker).

In all these conditions, for you to be tax assessable, your annual net earnings must be at least $400 or more. You are also required to pay self-employment tax if you work for a church or a qualified church-controlled organization exempt from Social Security and Medicare and you earn more than $108.28 or more annually (unless you are personally exempt from self-employment tax).

Note that the above definition helps answer the question, - What taxes does a self-employed person pay? - because you have to attain a specific amount as annual earnings to be taxable.

What Is Self-Employment Tax?

Self-employment tax is a tax that comprises Social Security and Medicare taxes and is primarily targeted at people who work for themselves. It is analogous to the Social Security and Medicare taxes deducted from the income of most wage earners.

Upon the enactment of the Self-Employed Contributions Act (SECA) in 1954, all self-employed individuals were mandated to pay both the employee and employer portion of the self-employment tax.

Social Security and Medicare taxes are split between the employee and his or her employer (7.65% each to amount to 15.3%). In other words, the SECA Act requires self-employed persons to pay the full 15.3% to cover their Social Security and Medicare obligations. The self-employment tax is also known as the SECA tax or SE tax.

Note that while SE tax helps answer the question: What taxes do the self-employed pay or what tax do I pay when self-employed? It is not the only tax paid by self-employed persons. So what taxes do the self-employed pay? More comprehensive info on this below. 

Do You Pay More Taxes If You Are Self-Employed?

Yes, even if you've been asking - "what taxes do the self-employed pay or what taxes do you pay if self-employed?" - one thing to bear in mind is that the self-employed usually pay more in taxes, on average. This should be considered by anyone opting for self-employment. But, they have also been provided with some avenues for reducing their tax burden.

For example, they are eligible to deduct 50% of their self-employment tax in addition to writing off personal and business tax deductions and enjoying tax breaks. If leveraged correctly, these extra tax benefits can compensate for the higher self-employment tax and bring about a lower total effective tax rate for the self-employed.

What Taxes Do The Self-Employed Pay?

Finally, it is time to answer the crucial question - What taxes do the self-employed pay? Though the focus is mainly on self-employment tax, the self-employed are also charged some other taxes such as:

  • Income tax: paid by all income-earning US nationals and businesses.
  • Sales tax: Nearly all US states charge tax on sales, (cities and county sales taxes may also apply). Sales tax is collected by sellers who then pay it to the states, cities, or counties on a regular basis

In other words, you should include income tax, and sales tax to self-employment tax whenever asked: What taxes do the self-employed pay? or what tax do I pay as a self-employed?

What Do The Self-Employed Pay Tax On?

For self-employment tax, the self-employed pay tax on Social Security and Medicare. Income tax is a tax on a person's income while sales tax is a tax on goods and services.

What Does A Self-Employed Person Need To File Taxes?

All self-employed persons in the US are required to file an annual return and pay estimated tax quarterly.

Annual Return

To file your annual return, it is necessary for you to report your income (or loss) from a business you were in charge of or a profession you were involved in as a sole proprietor. To report your Social Security and Medicare taxes, it is compulsory to file Schedule SE (Form 1040): Self-Employment Tax.

The income or loss calculated on Schedule C or Schedule C-EZ will help you to determine the precise amount of Social Security and Medicare taxes payable by you during the year. You may find the instructions for Schedule SE valuable when filling out the form.

Quarterly Payments

For quarterly estimated tax payments, use Form 1040-ES: Estimated Tax for Individuals. The form has a worksheet similar to Form 1040. Be sure to keep your return details since the prior year’s return will be needed to fill out Form 1040-ES.

You can mail your estimated tax payments with the blank vouchers that come with Form 1040-ES or pay online via the Electronic Federal Tax Payment System (EFTPS). If it is your first year as a self-employed person, you will be required to indicate your expected income estimate for the year.

Note that you must have a Social Security number (SSN) or an individual taxpayer identification number (ITIN) to pay self-employment tax.

What Is The 20% Self-Employment Deduction?

Sole proprietorships such as Self-employed persons, and other small business owners are eligible for what the IRS calls a qualified business income (QBI) deduction – also called the Section 199A deduction – for tax years beginning after December 31, 2017. The QBI deduction allows some sole proprietorships to exclude up to 20% of their business income from federal taxes. Apart from sole proprietors, other forms of businesses such as partnerships, S corporations, and some trusts and estates are also eligible for the QBI.

The IRS defines the QBI as “the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally, this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (e.g., SEP, SIMPLE, and qualified plan deductions).”

The IRS website lists 14 exclusions from the QBI. Among them include income that is not effectively connected with the conduct of business within the United States, certain dividends and payments in lieu of dividends, and investment items such as capital gains or losses among others.

What Percentage Does The Self-Employed Pay In Taxes

The self-employment tax rate is 15.3% (as noted above). The rate is made up of two components: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

The Social Security tax rate is 6.2% for an employee and 6.2% for the employer. Therefore, the rate for a self-employed worker is 12.4% (6.2% + 6.2%). Similarly, the Medicare tax rate is 1.45% for an employee and 1.45% for the employer. Therefore, the rate for a self-employed worker is 2.9% (1.45% + 1.45%). 

How Much Should I Set Aside For Taxes If Self-Employed?

As a self-employed person, 92.35% of your net earnings from self-employment are subjected to tax. Net earnings is calculated by subtracting ordinary and necessary trade or business expenses from the gross income you derived from your trade or business. This means that you first have to determine your net self-employment earnings and then, calculate 92.35% of these earnings to find out your total self-employment tax amount.

Hence, you should set aside 15.3% of this total amount plus the amount indicated by your tax bracket. Note that The Tax Rate Schedule is based on your filing status (e.g., single, married filing jointly, married filing separately, and head of household) and your income.

Final Thoughts

While not an encyclopedia, this article should have helped provide you with some insight into the crucial question: What taxes do the self-employed pay or if you are self-employed what taxes do you pay? However, in these digital days, all businesses, including the self-employed need efficient accounting tools to cope effectively with taxation and all other business accounting matters.

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