Self Employment Tax Rules

Make sure you understand everything involved!

Taxes can be complicated even if you’re not self employed. They can become much more complex if you’re running your own business or work as an independent contractor. Since your employer isn’t withholding taxes as they might in a traditional W2 position, it is up to you to understand what taxes you will owe and pay them appropriately.

Not only do you have to keep track of your income and qualified business expenses – you may also have to make quarterly estimated tax payments. In short, taxation is a bit different if you’re self employed.

Self Employment Tax

When you work for an employer, a certain amount of money is withheld from your paycheck and given to the federal government. An additional tax is paid by the employer, that you don’t even see taken out of your paychecks. Basically, you pay half of the tax out of your paycheck and your employer pays the other half. This tax money is used to pay for social security benefits and medicare. This amount is taken off the top. There aren’t any deductions for social security/medicare taxes.

These same taxes apply when you’re self-employed. However, you must pay them yourself. Unfortunately, they don’t just disappear from your paychecks like they do when you’re a W-2 employee. Since you employ yourself, you end up paying a single tax that is about twice the amount of the tax you would pay if you were traditionally employed by a different company. This tax is the self-employment tax.

The Self-Employment Tax is a tax imposed by the federal government which goes towards these social security benefits and medicare. While paying it may certainly be annoying, it’s important if you want to collect social security when you retire. The more you earn and pay into the program, the more you will be given when you finally retire.

Do not confuse self employment tax with income tax. They are two entirely different taxes that you must handle.

Calculating Self Employment Tax

For the 2024 calendar year, the self-employment tax rate is 15.3% of 92.35% of your total earnings. 12.4% goes towards social security and 2.9% towards medicare.

If you earn or expect to earn over $168,600, the rules change and you don’t pay the social-security part of the tax on the amount above 168k. You must pay self-employment taxes if you earned over $400 from any self-employment activities during the year.

First, you must determine your net earnings: \(\text{net earnings (profit)} = \text{total revenue} – \text{total qualified expenses}\)

92.35% of the net earnings is subject to self-employment taxes. So you don’t have to pay any federal taxes on 7.65% of your income.

Unless you only have a small amount of income, you’ll want to use tax and accounting software (or hire an accountant) to keep track of your income.

You can multiply your total earnings by 92.35% and the tax rate (15.3%) to determine how much you will owe.

\(\text{net earnings} \times 0.9235 \times 0.153 = \text{total self-employment tax owed}\)

You may be eligible for credits that slightly lower the self-employment tax, but plan on paying the full amount just in case.

Also note that you do not subtract the standard deduction from your net earnings before calculating the self-employment tax. The standard deduction applies to your federal income tax, not self-employment tax.

Example:

Scenario: You are a self-employed person who works part time as a caregiver for animals and children. You brought in $22,500 and spent $1000 on self-promotion, membership services, office supplies, and your “business” phone bill. You have receipts for all these items and keep track of income and expenses with accounting software. So you earned $21,500 last year.

You calculate your self-employment tax like this:

\($21,500 \times 0.9235 \times 0.153 = $3037\)

So you would owe $3037 in taxes that year for the self-employment tax, besides the federal income tax.

Enter your net income and click the button to calculate taxes.

Federal Income Taxes

Federal income tax is subject to the standard deduction. You may also use itemized deductions if you believe you have a significant amount of qualifying deductions. For most people, the standard deduction is the route you’ll go with.

For 2024, the first few income tax brackets for singles are:

• 10% on the first $11,600
• 12% on the amount from $11,600 to $47,150
• 22% on the amount from $47,150 to $100,525
• 24% on the amount from $100,525 to $191,950
• 32% on the amount from $191,950 to $243,725
• 35% on the amount from $243,725 to $609,350
• 37% on anything above $609,350

For a full list of tax brackets and rates, see the IRS website.

The Standard Deduction

The standard deduction is a set amount you may subtract from your total income before calculating how much federal income tax you owe. Again, for singles in 2024, the amount is $14,600.

Let’s examine the scenario from earlier, with the individual making $21k a year.

Scenario: You are a self-employed person who works part time as a caregiver for animals and children. After a few minor expenses, you earned $21,500 last year.

To calculate the federal income taxes this person would owe, we would do this:

\(\text{total amount taxable} = \text{total income} – \text{standard deduction}\)

For this person, it would be:

\(\text{total amount taxable} = $21,500 – $14,600= $6,900\)

This means only the first bracket of the income tax would apply. They would pay 10% of $6,900, so $690 in income tax.

Note that if you qualify for a significant amount of deductions (donations, school payments, child-related, homeowner related, etc.) valued over the standard deduction amount, it makes sense to do an itemized deduction instead. Your tax calculating software should help with this.

Each Tax Bracket Applies…

Say you make $50,000. After the standard deduction, your total taxable income is $35,400. This puts you in the second and the first income bracket. You pay 10% on the first $11,600, and 12% on the next $23,800. You do not pay 12% on the entire $35,400. The 12% tax rate only applies to the amount between $11,600 and the next bracket at $47,150.

Scenario: Earning $100,000 filing single. (Note, this part was done with 2022 tax rates)

First, calculate total taxable income after deduction in 2022.

\($100,000 – $12,950 = $87050\)

The total taxable income is $87,050. The first $10,275 is taxed at 10%, so they owe $1,027.50 in taxes on that amount.

They’re taxed at 12% on the next bracket up to $41,775. This means they owe $4,807.50 in total for the first two brackets ($1,027.50 from the first and $3,780 from the second).

This leaves them with a tax rate of 22% from $41,775 to $89075. Since they have $87,050 in taxable income, they only owe 22% of the amount up to $87,050. So $45,275 ($87,050 – $41,775) is taxed at 22%. They owe $9960.5 in the third bracket.

In summary, they owe $1,027.50 in taxes on the first bracket, $3,780 in the second, and $9960.50 in the third. The total amount of federal income tax they pay should be $14,768.

Quarterly Estimated Tax Payments

If you expect to owe more than $1000 in a calendar year you are supposed to pay quarterly estimated taxes. This means anyone earning over about $6000/yr should do this.

When you work for a traditional employer, they withhold taxes from each paycheck and forward them to the government on a monthly basis. In the eyes of the IRS, that money belongs to the government when you earn it. The same applies to self-employment taxes.

Since you don’t have an employer withholding these taxes each month, the government still expects payments regularly. For self-employed individuals, this means making a quarterly estimated tax payment four times a year.

If you are in your first year of business, you don’t technically have to pay quarterly estimated taxes. However, you should still be prepared to pay the full amount come next tax season.

Determining The Amount

You are expected to estimate the amount of taxes owed each quarter for both income tax and self-employment tax. Depending on your business, this may be tricky, as you won’t know exactly how much money you’ll earn each quarter and therefore cannot calculate which tax bracket you’ll end up in at the end of the year.

Basic Example (Constant Income)

Suppose you’re self employed, but your business is very steady. You earn 100k a year, and expect to make it evenly across the year. So you’ll earn roughly 25k each quarter.

In this case, you can simply calculate your taxes based on the total amount for the year, and pay one quarter of this amount each time.

\(\text{quarterly estimated payment} = \frac{\text{total income tax} + \text{total self-employment tax}}{4}\)

We calculate that the person making 100k/yr can expect to pay $14,768 in income taxes and $14,129 (92.35% * 15.3% of 100k) in self-employment taxes. This means they will pay $28,897 in federal taxes, which works out to $7,224 each quarter. This person should set aside $7,224 every quarter or $2408 a month to pay the IRS.

Seasonal Income

If you’re in a position where your income may vary widely from month to month, it may be more difficult to estimate your payments. There are a few approaches.

If you’ve been in business for over a year, you may already have a general idea of what your yearly income looks like. You can divide the taxes you expect to owe by four if this is the case. If you make significantly more money during one season than another, you could plan on setting a larger fraction of the money aside for the high-income months, and pay a lesser amount during the slower quarters.

Finally, if you end up making a lot more money than expected during one month of the year, you can re-estimate your taxes and pay more during that quarter.

As the year progresses, you must keep track of your income and recalculate your estimated taxes. If business picks up unexpectedly, you may have to make a larger estimated payment. If business slows down considerably, a smaller payment. The payments do not all have to be equal, as long as they add up to the right amount before the next tax season. 

Scenario: You made $40,000 last year and expect to make about the same amount this year. You’re most busy during the holiday season and at the start of the year (quarters 1 and 4). You made about 33% of your money in Q1, 34% in Q2 and Q3 combined, and the remaining 33% in Q4.

In this example, you could estimate the total federal taxes (income and self-employment combined) somewhere around $6000. Then, you could pay $2000 in Q1, $1000 in Q2, $1000 in Q3, and $2000 in Q4. Or, if you have enough in savings, you could just pay $1500 each quarter. How you do it is up to you. As long as you do it in good faith, and pay at least 90% of your total tax liability with estimated taxes, the IRS will be satisfied. Just don’t do something silly, like making three $10 payments for the first 3 quarters and a $6000 payment at the end (unless you truly made next to nothing during the first three quarters and a ton of money in the last).

Other Thoughts

You’ll Get Better

If you plan on continuing to be self-employed for several years to come, you will naturally get better at estimating taxes. The IRS doesn’t expect you to make a perfect guess, but they expect you to make a reasonable attempt within certain guidelines.

Underpayment Penalty

Your goal for the entire year is to make sure you’re not significantly underpaying or overpaying the government taxes. When tax season comes around, the IRS expects the estimated tax payments you made the previous year to cover 90% or more of the total calculated balance. If you owe a difference of more than $1,000 and you paid less than 90% of what you owe, you must pay an additional penalty for underpayment.

Suppose you paid $2,000 total in estimated taxes last year. This year, during tax season, you realize you actually owe $2,100. You would just pay the $100 with no penalty.

Now suppose you owe $10,000 in taxes, but you only paid $6,000. You’ll owe an additional $4,000 besides a penalty come tax season.

Finally, it’s safer to overpay your taxes than underpay them. You will get the overpayment back as a refund. However, if you overpay the government too much money, you are effectively losing money as the government won’t be returning your money with interest. It’s OK to overpay a little, but avoid overpaying too much.

Local & State Taxes

Income taxes vary wildly from state to state. Always check with local regulations regarding taxation of your income.

Some cities and states charge sales tax on certain services. Check if these rules apply to you and get a tax license if needed. Collect and remit sales tax on the required basis.

Making Payments

If you did not pay any quarterly estimated taxes during the previous tax year, you can calculate them and pay them as a lump sum when you file your next tax return. Remember, if you forgot to make your estimated payments, you will have to pay an additional penalty!

If you’re supposed to be making quarterly estimated payments, you can pay the IRS directly on their website.

Of course, keep detailed records of each payment you make to the IRS.

Tax Returns

As a side note, many services allow you to file your taxes online for free if your adjusted gross income is under $79,000. Check out the Free File page on the IRS website.