Self-Employment Taxes and Small Business: What You Need to Know
Being your own boss and successfully being able to make a profit is a great thing. Not only is it great for you, it is great for the economy and in helping create jobs for others. Being a profitable self-employed individual, however, also comes with having to pay the self-employment tax (SE tax).
The SE tax is a tax of 15.3% that self employed individuals must pay in addition to normal income taxes. With that being said, many self employed individuals feel it is unfair to be charged an additional tax that W-2 employees do not get charged. It is important to understand that the IRS isn't trying to be unfair or attempting to deter individuals from being self employed, they are just charging this tax instead of a different one.
The aim of the IRS is, in fact, to collect the same amount of taxes from the self employed individual as they would from the salaried worker.
When individuals are paid on a salary basis the company paying them must cover half of their social security (12.4%) and Medicare (2.9%) taxes. Being self employed means you are both the employer and employee -- and you are required to pay the full amount instead of just half.
Yes, this does look like you are having to pay more taxes out of pocket, but you must realize that most employers will factor in this cost into an employees pay and will pay them less because they know they will be required to pay half of their social security and Medicare taxes. So a salaried worker will only see 6.2% (12.4%/2) and 1.45% (2.9%) deducted from their paychecks for Social Security and Medicare respectively, while-self employed individuals were required to pay the full 15.3%.
For 2011, however, the SE Tax will be 13.3%.
Calculating the Self-Employment Tax
The self-employment tax applies to individuals that earn at least $400 in a tax year through self-employment. The 15.3% self-employment tax only applies to the first $106,800 (as of 2009, updated annually) of self employment net earnings. After $106,800, only 2.9% Medicare part of SE tax is applied.
Among the benefits of being self-employed are the various tax deductions the IRS allows. One deduction that benefits the self-employed is being able to deduct one-half of the SE tax from their income taxes. Below is the simplified calculation to calculate the self-employment tax for 2011.
- Begin with the profit from your business
- Multiply by 92.35%
- Multiply by 13.3% (taking into account 2% reduction in 2011)
- Let's call the result "Y"
- Then, if "Y" is $106,800 or less, multiply this by .133 to find the SE Tax. If "Y" is more than $106,800 then multiply this by .029 and add $11,107.20 to the product.
Remember that half of the SE Tax (or half of the employer portion of the SE tax) is deductible, so make sure you calculate that as well.
Being self-employed comes with many rewards, challenges and taxes. The self-employment tax is the one tax that stands out most to those individuals making a recent transition from W-2 employee to earning profits through their own ventures. Yes, it may seem like you are paying more to the IRS than before, but you must realize that it is just because your employer was picking up the other half the Medicare and social security taxes.
All in all, the IRS tries to collect about the same amount of taxes from your earnings if you are self-employed or earning wages from a company. However, the IRS will likely collect less taxes from you when you are self-employed because of the additional tax deductions you are allowed, one of them being 50% of the SE tax.
