How Do Self-Employment Taxes Work?

What Every Self-Employed Person in the U.S. Needs to Know About Self-Employment Taxes

Whether you’re a freelancer (independent contractor), or small business owner, navigating self-employment comes with its own set of responsibilities—including self-employment taxes (SE taxes). Unlike traditional employees who have taxes withheld from their paychecks, self-employed individuals are responsible for calculating and remitting their own taxes to the IRS and possibly state and local tax agencies.

Self-employment taxes (SE taxes) vs taxes for self-employed people

The language around taxes for self-employed people can get confusing. Self-employment taxes (SE taxes) are just one piece of the taxes that self-employed people must pay. Depending on your business and location, you may need to pay the following taxes:

  • Federal personal income tax
  • Self-employment tax (SE tax)
  • State taxes (most states)
  • Local business tax and other taxes (depending on the city or county)
  • Business entity taxes (depending on what type of business structure you have)
  • Sales taxes (if you sell products)
  • Payroll taxes (if you have employees)

What are self-employment taxes?

Self-employment taxes are essentially the self-employed individual’s version of FICA (Federal Insurance Contributions Act) taxes paid by traditional employees. Self-employed people must pay essentially double the FICA taxes that employees pay, as they must pay both the employer and employee portions (a total of 15.3%). While that may seem unfair, it’s not really double, as you can deduct 50% of the self-employment tax from your personal taxable income. And keep in mind that business owners and other self-employed people can take various additional deductions, discussed briefly below.

The primary components of self-employment taxes include:

1. Social Security Tax: Self-employed individuals are required to pay the Social Security tax, which funds retirement, disability, and survivorship benefits. The Social Security tax rate for self-employed individuals is 12.4% (twice the rate of traditional employees).

As there is for employees, there is a cap on the income (whether from self-employment or wages) that’s subject to this tax, known as maximum taxable earnings, or the wage base limit. The 2024 wage base limit is $168,600, and this amount generally increases each year. So if you were to earn net business income of $200,000, for example, you would only be subject to social security tax on the first $168,600, with zero social security tax on the remaining $31,400.

2. Medicare Tax: Similar to traditional employees, self-employed individuals must pay the Medicare tax, which funds healthcare coverage for individuals aged 65 and older. The Medicare tax rate for self-employed individuals is 2.9% (twice the rate of traditional employees), with no wage base limit. Additionally, high-income self-employed individuals may be subject to an additional 0.9% Medicare tax on earnings above certain thresholds.

How to pay self-employment taxes

1. Determine Net Profit: Self-employment taxes are based on net profit, which is calculated by subtracting business expenses from gross income. It’s crucial for self-employed individuals to maintain accurate records of income and expenses throughout the year to calculate their net profit correctly.

2. Calculate Self-Employment Tax: Once the net profit is determined, self-employment tax is calculated by multiplying it by the combined Social Security and Medicare tax rates (15.3% as of 2024). This represents the total amount of self-employment tax owed.

3. Report and Pay Taxes: Self-employed individuals report their self-employment tax liability on Schedule SE (Self-Employment Tax) of Form 1040 when filing their annual income tax return. They may also need to make estimated tax payments throughout the year to avoid underpayment penalties.

What tax deductions and credits are available for people who are self-employed?

While self-employment taxes can seem daunting, there are several deductions and credits available to help reduce the tax burden for self-employed individuals:

1. Deduction for Self-Employment Taxes: One unique aspect of self-employment taxes is the ability to deduct half (50%) of the self-employment tax when calculating adjusted gross income (AGI) for income tax purposes on the Form 1040. This deduction effectively reduces the taxable income of self-employed individuals, providing some relief from the tax burden.

2. Qualified Business Expenses: Self-employed individuals can deduct ordinary and necessary business expenses, such as office supplies, equipment, travel, and professional services, from their gross income to lower their taxable income.

3. Self-Employed Health Insurance Deduction: Self-employed individuals may be eligible to deduct the cost of health insurance premiums for themselves, their spouses, and dependents when calculating their adjusted gross income.

4. Retirement Contributions: Contributions to qualified retirement plans, such as SEP-IRAs, SIMPLE IRAs, or solo 401(k) plans, are tax-deductible and can help self-employed individuals save for retirement while reducing their taxable income.

5. Qualified Business Income (QBI) Deduction: The Qualified Business Income (QBI) deduction, also known as the Section 199A deduction, is a tax deduction available to eligible self-employed individuals, sole proprietors, partners in partnerships, and shareholders in S corporations. This deduction allows qualifying taxpayers to deduct up to 20% of their qualified business income (QBI) from their taxable income, thereby reducing their overall tax liability.

Related Reading

Taxes for Small Business Owners

Taxes for Freelancers

Guide to Laws for Business Owners

Guide to Laws for Freelancers

Guide to Laws for Taxpayers

What are Payroll Taxes?

See more about taxes for self-employed people at the IRS website

Photo credit: Image by lookstudio on Freepik

Share the Legal Info With Your Friends: