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Thursday, July 9, 2015

Self Employment Tax (Part 1)

An article from

Being your own boss, setting your own hours, enjoying the full fruits of your labor without interference from meddling middle managers and corporate overlords — that's the self-employed dream!

But there are trade-offs for all of that freedom and autonomy. The self-employment tax is a great example of one of the trade-offs that comes with working for yourself. If you get a regular paycheck from an employer, you probably noticed those deductions labeled "FICA – Social Security" and "FICA – Medicare." FICA stands for the Federal Insurance Contributions Act, which requires every American worker to pay into the Social Security and Medicare trust funds in order to claim benefits upon retirement.

For 2015, the total cost of FICA contributions is 15.3 percent of earned income. If you work for someone else, your employer pays half of your FICA contributions (7.65 percent), and you're on the hook for the other half. If you are self-employed, however, you need to pay the entire 15.3 percent yourself. That, my friend, is called the self-employment tax.

In truth, the self-employment tax isn't some kind of punishment for independent workers and small business owners. Its sole function is to make sure that self-employed people are covered by the same "safety net" insurance as salaried workers. By making FICA contributions on your earnings, you earn credits in the Social Security system, allowing you to claim a monthly benefit throughout retirement. The same is true for Medicare benefits. By paying self-employment tax, you are covered in your golden years.

So how exactly do self-employed folks calculate their self-employment tax, and is it true that you have to pay estimated taxes four times a year? Let's start by defining who fits the description of "self-employed" according to the only source that matters: the IRS.

Who Pays Self-employment Tax?

The broadest definition of the self-employed is people who are in business for themselves. That's not quite specific enough for the IRS, so it has come up with categories of workers who qualify as self-employed:

  • A sole proprietor is a person who owns his or her own unincorporated business. A sole proprietor is self-employed, even if the business has other employees.
  • An independent contractor owns and operates his or her own unincorporated business and is paid only for services rendered, not on a salary or wage basis. Independent contractors typically do work for other businesses.
  • Members of an unincorporated partnership each qualify as self-employed, because profits from the shared business are "passed through" to their individual income taxes.
  • Similarly, spouses who run an unincorporated business together can elect to file taxes as a qualified joint venture in which both spouses are considered self-employed.

Unsure whether you're an independent contractor or an employee? Here's a tip: look at the last paycheck you received. Was it written out for the full amount, or did the payer withhold federal and state income tax and FICA contributions? If money is already being withheld from your paycheck, you are an employee and can stop worrying about self-employment tax.

Keep in mind that you don't have to be a full-time self-employed worker to qualify as self-employed. Many self-employed people operate home-based business in their spare time, or hire themselves out for part-time work in addition to holding down a "day job." The IRS doesn't care whether you are full-time, part-time or one-time.  If you made more then $400 in self-employment income, the IRS wants a piece of it.

One last note, the self-employment tax rules apply to workers of all ages, even folks who are already collecting Social Security and Medicare benefits. So if you've retired from your office job and start painting houses for some spending money, the IRS still wants its full cut.