Paying your Social Security tax when you’re an employee is a pretty simple affair, since it’s taken right out of your paycheck. But what about people who work for themselves? How are they taxed, and how do benefits accrue for them?
If you are self-employed and make more than $400 a year, you also have to pay Social Security taxes, but you do so when you file your income taxes. You’ll also have to pay your share of the Medicare tax, since that’s also not being deducted from your paycheck. Together, these two components are referred to as the “self-employment tax.”
In addition to filling out a Schedule C (profit or loss from business), you’ll have to complete a Schedule SE to determine your self-employment tax. That’s on top of the income tax you’ll owe on the earnings you generate through your business.
According to the IRS, you’re classified as “self-employed” if you run a trade or business either by yourself or under a partnership. This covers everyone from a freelance graphic designer to someone who runs a general contracting business with a partner.
Calculating Your Tax Liability
If you’re an employee, you pay 6.2 percent of your income in Social Security tax—though only on the first $128,400 of your salary—and an additional 1.45 percent for Medicare tax on your entire earnings. The employer kicks in an equal amount for each.
But self-employed individuals have to pay both the employee and employer portion of the tax. That means they have to fork over 12.4 percent for Social Security taxes and 2.9 percent for Medicare—a total of 15.3 percent. The government reasons that people who work for themselves are both employer and employee, so they have to pay both shares.
The good news is that you’re allowed to take a couple of deductions that reduce your tax bill, alleviating at least a part of the extra tax you’ll have to pony up.
First, in determining your self-employment tax, you can reduce your net earnings by the employer’s portion of the Social Security and Medicare taxes, or 7.65 percent. Say you made $50,000 in net earnings for the year. You’d only have to pay self-employment taxes on $46,175 of that amount ($50,000 x 92.35 percent).
You’d multiply $46,175 by 15.3 percent (the combined Social Security and Medicare tax rate) for a total self-employment tax of $7,046.78.
The other tax break comes from deducting the employer share of the self-employment tax from your income tax, since the IRS treats that portion as a business expense. In our example, the individual owes $7,046.78 in self-employment tax and can reduce his or her taxable earnings by half of that, or $3,523.39.
You enter this amount in the adjusted gross income section of Form 1040 where it says “Deductible part of self-employment tax.” It’s the part of the form where you deduct things like Traditional IRA contributions and student loan interest.
Unfortunately, you’re still paying more in Social Security and Medicare taxes than typical employees. But at least the two deductions help mitigate that extra expense.
Bear in mind, too, that you don’t have to pay self-employment tax on every cent you bring in—only on your actual profits. Needless to say, it pays to keep a detailed record of any business expenses and enter them on your Schedule C so you can reduce your net income.
Qualifying for Benefits
The Social Security Administration (SSA) uses a metric known as a “work credit” to determine your eligibility for benefits. The amount of work credits you need depends on your date of birth. But the maximum that anyone needs is 40 credits.
For 2018, self-employed workers earn one work credit for every $1,320 they earn in a given year, just like other employees. The maximum number of work credits you can earn in a year is four. So if you make $5,280 or more in net earnings, you’ve maxed out your credits for the year.
The actual amount you receive through Social Security is based on your lifetime earnings. The SSA calculates your averaged monthly earnings for the 35 years in which you earned the most money. Using a mathematical formula, it calculates your basic benefit amount based on your average earnings.
The more you earn, whether it’s as an employee or from your own business, the bigger your check will be each month.