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Self-Employment Tax vs Income Tax

Self-Employment Tax vs Income Tax
Ines Zemelman, EA
08 September 2021

The IRS collects self-employment taxes from self-employed business owners. The taxes are based on the earnings you earn as an independent contractor or as a sole proprietor (not a corporation). The Self-Employed Contributions Act (SECA) is the name of the tax on self-employment.

According to the IRS, self-employed individuals are required to pay self-employment taxes (SE taxes) along with income taxes. The self-employment tax is a federal Social Security and Medicare tax imposed on individuals who are self-employed. The deduction is similar to what most wage earners receive in Social Security and Medicare taxes. As a general rule, whenever the term "self-employment tax" is used, it is referring to Social Security and Medicare taxes only.

The tax rate for self-employed individuals in 2021

In self-employment, you must determine how much income you made. In other words, you have to maintain accurate records of your earned income and the expenses associated with running your business. 

A self-employed person pays a 15.3% tax on their reported earnings. This rate is composed primarily of the 12.4% Social Security tax plus the 2.9% Medicare tax. Even though you don't have an employer, the IRS sees you as both an employer and an employee since you're self-employed. When you are self-employed, you are therefore responsible for both of these portions of taxes.

If your business has income and expenses, fill out Schedule C when filing taxes. You can calculate your net profit from self-employment by subtracting the expenses from the income. You are taxed on your net profit the same way as the rest of your income when you file your personal income tax return. 

The amount your clients paid you during the year is reported in 1099 forms that you will receive from your clients if you are an independent contractor. 1099 forms are records that indicate you were given or paid money by a person or company other than your employer. You and the IRS will receive copies of the 1099 form, which is completed by the payer. 

What are employment or income taxes?

Employees are responsible for paying federal income tax, FICA taxes (Medicare and Social Security), and additional Medicare taxes. These taxes are withheld from employees' paychecks by their employers, and the employers deposit these taxes with the IRS and report them.

Employees are required to fill out Form W-4 at the time of hire and follow the withholding tables to determine what percentage of federal income taxes are withheld from their pay.

An employee's FICA taxes are split between the employer and the employee according to the employee's payment amount. As per IRS Withholding rates, an employer's share of social security taxes is 6.2%, and the employee's share is 6.2%, making the total 12.4%. Currently, the employer is paying 1.45% of Medicare and the employee is paying 1.45%, for a total of 2.9%. Together they pay 15.3%, or 7.65% each.

An employer's withholding of FICA taxes and income taxes from employees' paychecks is reported to them on Form W-2, the annual wage and tax report. The employee must then disclose this supplemental information when filing their tax return using Form 1040 or Form 1040-SF.

The W-4 is used by employers to determine how much tax should be withheld from employees' salaries, while the W-2 is the employer's statement of what they paid employees and how much tax was withheld.

Taking deductions for self-employment

The self-employment tax you pay can be deducted from your income taxes in half. You will have to pay the tax due each year when it is due, but you will be able to deduct $2,500 at tax time if your Schedule SE states that you owe $5,000 in self-employment tax for the year.

Those who work for themselves, such as freelancers, self-employed, and independent contractors, can take advantage of many tax deductions. A tax break could be offered on your car, home, and insurance, retirement plan contributions, or even college tuition.

Is self-employment tax higher than income tax?

Those who are self-employed must pay federal income taxes the same way as everyone else. There are two differences: they don't have employers who collect FICA taxes and send them to the IRS, nor do they share in the cost of Social Security and Medicare.

Do you pay federal tax on self-employment?

Individuals who are self-employed are responsible for filing and paying their own federal income tax, Social Security tax, and Medicare, either as part of their annual tax return or through a quarterly estimated payment. You can figure out if you need to file quarterly estimated tax by using the worksheet in Form 1040-ES, Estimated Tax for Individuals. If you wish to file Form 1040-ES, you will need to have your prior year's tax return.

Have you heard of the term 'two streams of income'?

What happens if you work both as an employee and as a contractor? Does self-employment tax and employment tax have to be paid at the maximum rate? There is a yes and a no. The income tax must be paid on any income you earn, regardless of its source, including that which comes from self-employment and employment. Social Security and Medicare taxes must be paid by self-employment, and your employer will also be required to collect FICA taxes from your paychecks. The Social Security tax is subject to a maximum amount.

Hire a professional

Complexity and constant change make tax codes difficult to understand, which is why tax professionals stay on top of it, so they can work with you to ensure that you receive any and all deductions and credits you are entitled to. An experienced tax professional can maximize your refund or make tax planning more efficient. 

Ines Zemelman, EA
Founder of TFX