Self-Employment Tax Definition

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Self-Employment Tax Definition

What Is the Self-Employment Tax?

The phrase self-employment tax refers to the federal government’s collection of taxes from self-employed people and small company owners to support Medicare and Social Security. The self-employment tax is identical to the FICA taxes paid by employers. It is required when a person earns $400 or more in self-employment income during the tax year, or $108.28 or more from a tax-exempt church. IRS Form 1040 Schedule SE is used to calculate and report the tax. Individuals who earn less than these criteria through self-employment are exempt from paying taxes.

Key Takeaways

  • Self-employment tax is levied on self-employed people and small company owners who do not pay withholding taxes.
  • The self-employment tax, which is reported on IRS Form 1040 Schedule SE, pays for Social Security and Medicare.
  • Sole proprietors, freelancers, and independent contractors who carry on a trade or company are examples of self-employed workers.
  • Self-employed individuals earning less than $400 per year (or less than $108.28 from a church) are free from paying the self-employment tax.
  • The CARES Act postpones payment of the employer component of Social Security taxes for 2020 to 2021 and 2022.

How the Self-Employment Tax Works

The self-employment tax is intended to be collected from self-employed employees who do not otherwise pay withholding taxes. Sole proprietors, freelancers, and independent contractors who operate a trade or company are included. The Internal Revenue Service may regard a member of a partnership that operates a trade or company to be self-employed (IRS).Self-employed people must pay self-employment tax in order to get Social Security benefits when they retire.

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Both the corporation and the employee are taxed in any business to pay for the two primary social welfare programs: Medicare and Social Security. Individuals who are self-employed are considered both the corporation and the employee in the eyes of the IRS, therefore they must pay both components of this tax. This is how it works.

The Social Security tax is levied at a rate of 6.2% on employers and 6.2% on employees. As a result, a self-employed worker gets taxed at 6.2% + 6.2% = 12.4% since they are both an employer and an employee. In 2021, the Social Security tax is only levied on the first $142,800 of self-employment income generated, for a maximum tax of $17,707.20. This amount rises in 2022 and applies exclusively to the first $147,000 of income, for a total tax of $18,228.

The Medicare tax is levied at a rate of 1.45% for employers and 1.45% for employees. As a result, a self-employed worker gets taxed at 1.45% + 1.45% = 2.9% since they are both an employer and an employee. Medicare taxes have no income limit. As a result, the total self-employment tax rate is 12.4% + 2.9% = 15.3%. In 2021, a self-employed individual with a total net income of $137,700 would owe $21,068.10 in taxes ($137,700 x 15.3%).

Self-employment taxes are tax deductible. While the tax is levied on a taxpayer’s company earnings, the IRS allows them to claim the “employer” half of the self-employment tax, or 7.65% (calculated as half of 15.3%), as a business deduction when computing their income tax.

Special Considerations

Self-employed workers are not subject to withholding tax. As a result, the IRS compels taxpayers to make quarterly estimated tax payments to cover their self-employment tax liability, in addition to their federal and state income tax liabilities.

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President Donald Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act into law on March 27, 2020, deferring payment of the employer component of self-employment taxes due to Social Security from March 27, 2020 to December 31, 2020. It postpones payment of half of the taxes until December 31, 2021, and the other half until December 31, 2022.

High-income earners must also pay a self-employment tax. Earnings exceeding $200,000 ($250,000 for married couples filing jointly) are subject to an extra 0.9% Medicare tax as a consequence of the Affordable Care Act (ACA).

Example of the Self-Employment Tax

Individuals generally pay self-employment tax on 92.35% of their net earnings, not 100% of their total earnings, contrary to popular belief. This is how it works.

Assume a person owns a human resource consulting firm and estimates their total net income for 2021 to be $200,000 after company expenditures are eliminated. Their self-employment tax will be calculated at 92.35% of $200,000, for a total of $184,700. This sum exceeds the Social Security part of the self-employment tax limitation. As a result, Robin’s self-employment tax liability will be $23,063.50. This figure is calculated as follows:

($142,800 x 12.4%) + ($184,700 x 2.9%)

$17,707.20 + $5,356.30

They may claim an above-the-line deduction for half of their self-employment tax, or $23,063.50 2 = $11,531.75, when they file their 2021 income tax return. In effect, they get a deduction for the “employer” share of their self-employment tax (6.2% Social Security + 1.45% Medicare = 7.65%).

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