Minimizing Self-Employment Taxes: What You Need to Know

Working without a boss is often seen as the American dream, offering a sense of freedom and satisfaction that is hard to find in traditional employment. Whether you’re running a small business with employees or working as a freelance graphic artist, being your own boss allows you to make decisions and shape your work life according to your own vision. However, when tax time rolls around, the dream can quickly turn into a nightmare. As a self-employed individual, there are certain taxes that you must pay, which can be more burdensome compared to when you were an employee. So, what are these taxes and is there any way to minimize them?

One of the taxes that self-employed individuals must pay is the Self-Employment Contributions Act (SECA) tax. This tax is the self-employed version of the tax paid by employers and employees for Medicare and Social Security. While employed individuals only pay half of this tax, with their employer covering the other half, self-employed individuals are responsible for paying the entire tax themselves. The SECA tax is based on 92.35 percent of your net earnings from self-employment.

If you fall into one of the following categories recognized by the Internal Revenue Service (IRS), you are considered self-employed and subject to the SECA tax: sole proprietors, freelancers, independent contractors with a trade or business, and members of a partnership that carries on a trade or business. The SECA tax applies if you earn $400 net or more in one of these roles.

When you were an employee, you and your employer each paid 6.2 percent of your earnings for the Federal Insurance Contributions Act (FICA) tax, which includes Social Security. However, as a self-employed individual, you now have to pay the full 12.4 percent of your net income for the Social Security tax. It’s important to note that for 2023, this tax only applies to the first $160,200 of self-employment income, and in 2024, it increases to $168,600.

Additionally, self-employed individuals are also responsible for paying the Medicare tax. While this tax used to be split between employers and employees, self-employed individuals now have to pay the entire 2.9 percent themselves. Unlike the Social Security tax, there is no cap on income for the Medicare tax. However, higher earners may be required to pay an additional 0.9 percent Medicare tax if their income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.

To make matters more complex, self-employed individuals must make quarterly payments throughout the year. These payments are due on April 15, June 15, September 15, and January 15. Failing to make these quarterly payments can result in penalties and interest charges.

When you add up the total SECA tax, it amounts to 15.3 percent of your net income. However, it’s important to remember that you still have to pay your regular income taxes on top of this, which are based on your overall income.

While the SECA tax can be a significant burden for self-employed individuals, there are ways to reduce the impact. The IRS allows you to deduct half of the SECA tax from your taxable income. This deduction represents the amount an employer would have paid if you were an employee. By deducting this amount, your taxable rate decreases to 7.65 percent, which is half of the original 15.3 percent rate.

For example, let’s say your net self-employment income is $50,000. Only 92.35 percent of this income is considered taxable due to the SECA tax. This brings the amount of taxable income subject to the SECA tax down to $46,175. Applying the 7.65 percent tax rate, you would owe $3,532.39 instead of the original $7,064.78.

It’s worth noting that even if you have a side gig, such as being a handyman or selling items on platforms like Etsy or eBay, you are still required to pay income taxes, Social Security taxes, and Medicare taxes if your income exceeds $400. Both Etsy and eBay are required to report your income to the IRS, so it’s important to accurately report your earnings by filing a Form 1099 with your tax return.

When it comes to Limited Liability Company (LLC) S Corp owners, whether they are subject to the SECA tax depends on how they are paid. If you receive wages as an owner or employee of the S corporation, these wages are considered earned income and are subject to FICA tax for Social Security and Medicare. However, other net earnings that are passed through to the owners and are considered dividend income are not subject to SECA taxes. It’s important to note that the owner must materially participate in the business and cannot have passive income for this exemption to apply.

In summary, whether you’re self-employed or an employee, you still have to pay taxes for Social Security and Medicare. Self-employed individuals face the additional burden of paying the full amount themselves, which can be a significant expense. However, by deducting half of the SECA tax from your taxable income, you can reduce the impact of this tax. It’s also important to stay on top of your quarterly tax payments to avoid penalties and interest charges. If you have a side gig or own an LLC S Corp, it’s crucial to understand the specific tax obligations that apply to you. Consulting with an accountant can help ensure that you meet all your tax obligations while minimizing your tax liability.