Self Employment Taxes

Most people learn about Self Employment taxes when they file their first tax return after starting their business. This can be a very rude awakening, you started a new business, why are your taxes so much higher?

The answer is payroll taxes. When you are paid as an employee, receiving a W2 at the end of the year, each paycheck you receive is reduced by payroll taxes. There are four big ones:

  • Social Security Taxes (6.2%)

  • Medicare Taxes (1.45%)

  • Federal Withholding (no set rate)

  • State Withholding (no set rate)

Social Security and Medicare Taxes

The total rate for Social Security taxes is 12.4%, and the total rate for Medicare is 2.9%. Your employer is required to pay 50% of these and do so each month or quarter depending on their reporting requirements.

The result is that by the end of the year as an employee your Social Security Taxes and Medicare taxes have already been paid-50% from deductions from your paycheck, 50% from payments by your employer.

Withholding (Federal and State)

Neither Social Security nor Medicare taxes effect your income tax liability. That’s what withholding is for on your paycheck. Your paychecks are reduced by some amount of withholding, and these amounts are sent to the IRS or state agencies as prepayments towards your income tax liabilities.

Back to Self Employment Taxes

Whether you are an employee or self employed you are still liable for all the above taxes. That means that every dollar you make is subject to Social Security Taxes of 12.4% and Medicare taxes of 2.9% (you pay the total rate, because there is no employer to pay half.) Furthermore, the amount you make is also subject to regular Federal and State income taxes. This is often a huge surprise for tax payers because

  1. They only ever see 1/2 their Social Security and Medicare Liabilities as an employee

  2. They aren’t aware that they owe payroll taxes even if they aren’t an employee

What’s the takeaway? If you have started your own business you should make estimated tax payments throughout the year to prepay your tax liability. This is required by the IRS if you owe more than $1,000 by Tax Day and will prevent a nasty surprise at the end of the year. For more about estimated payments check out our article on them:

Estimated Payments.