People often get so swept up in the first exciting year of starting their own business, going freelance or contracting that they forget some of the more mundane, but nevertheless important changes that self-employment will bring. Along with a renewed passion for your career and control over your own destiny and potentially far greater financial rewards, there are also a number of downsides and financial hurdles to setting out on your own.
Self Employment Tax will be one of those hurdles. Self-Employment Tax is a tax that you were never required to pay as an employee, but essentially it is the self-employment version of the FICA (Federal Insurance Contributions Act) tax that is used to pay for social security and medicare and it comes out of your net earnings from your self employment. Back when you were employed by a company you probably never gave a moment’s thought to this payment because your employer would have been paying half of it, approximately 7.65% each. But now you are classified as self-employed, whether you are a sole proprietor or an independent contractor, you have to pay the full 15.3% levy yourself on your tax return. As long as you earn over $433 per annum, you must pay 15.3%. And once you reach $106,800 you then pay 2.9% for every dollar after that. The tax itself is split into two parts. Social Security receive 12.4% and Medicare receive 2.9%.
So how do you know if you need to pay it? Basically, if you’re self-employed in any way, you pay the tax. It is levied on net earnings from your business. Whether you file a Schedule C (Profit or Loss from Business), a Schedule F or a Schedule E with income from a partnership then you’re required to file a Schedule SE and pay the tax. However, it relates to income from your job and earnings, not from investments so investment income is not subject to Self-Employment Tax. Rents and royalties, dividends, interest and capital gains are therefore not taxed.
The next thing you need to consider is that when you were employed your employer would take care of paying this. Now the responsibility lies with you. Unfortunately going freelance means more paperwork and more responsibility. You need to calculate your Self-Employment tax on Schedule SE and enter this figure into the “Other Taxes” section of the 1040 form. This is so the IRS can differentiate between income tax and the SE tax. You will need to make estimates quarterly on your tax obligation in April June, September and January and if you don’t pay or they aren’t enough you could face penalties and interest.
There are, however, some ways to reduce Self – Employment tax. Firstly, you can charge your own business a rental charge for using your property. This income that you get from rent is not part of your self-employment and therefore is free from Self-Employment tax. Secondly, when calculating Self Employment tax you are permitted to reduce your income by 7.65% before you have to apply the tax rate. So if your net self-employed income is $100,ooo this is what you write on your 1040 for income tax. But on your Schedule SE the taxable amount is $100,000 less $7650 which comes to 92,350. This saves paying 15.3% tax on $7650, making a saving of $1170.
Alex Simmonds is a journalist and copywriter living in the UK. He can currently be found writing a daily blog on contracting and home-working for The Bedouin Group., a contractor portal.