How Does Self-employment Tax Work

Mar 29, 2018Business, Business Tax

Every day, individuals transition from working for an employer to being self-employed. The list of changes resulting from this transition are abundant, unfortunately the related tax consequences are often overlooked until it is too late.

As an employee, your employer withholds/pays from your earnings:

  • Employers withhold 6.2% on the first $128,400 (2018 limit) of each employee’s wages, matching an equal amount, and remitting this to the Social Security Administration (a total of 12.4%) for Social Security tax.
  • Employers withhold 1.45% of wages, matching an equal amount, and remitting to the Social Security Administration (a total of 2.9%) for Medicare tax. 
  • Employers withhold and remit federal and state taxes from employee’s wages for income taxes.

In total, an employer is remitting 15.3% on the first $128,400 wages for each employee with half coming from the employee and half coming from the employer. A self-employed individual is responsible for the entire self-employment taxes on the business’s net profit. The rate is 15.3% on the first $128,400 of profit, 2.9% on the profit in excess of $128,400.

Good News: Half of the self-employment tax is deductible on your federal tax return, reducing your taxable income.

Unfortunately, many first-year self-employed individuals are unaware of the self-employment tax and neglect including this in their cash-flow forecasts. The combined self-employment tax and income tax rate may be upwards to 50% of the net profit. As a result, not remitting deposits throughout the year may result in a large tax amount due. Additionally, an individual may be required to make regular tax deposits to the IRS and state or be charged penalty and interest when the Individual return is filed.

Although self-employment taxes are comparable to the combined amount employers and employees pay, a self-employed individual needs to be aware of the total payments they will pay the IRS, if not throughout the year, at year-end.

Need help?

Contact us today for business modeling and tax saving strategies that best fit your situation, saving you time and money. We look forward to speaking with you soon.

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