Self Employment Tax

With April 15th fast approaching, and a couple things lining the calendar for the next couple weekends, I thought I would bite the bullet, fire up TurboTax, and finalize my 2008 taxes.  Besides, the weather was dreary out and there wasn’t much else to do.  I ran through estimates earlier in the year, and thanks to a bit of self employment income, had already ruled out the chance of receiving a tax refund.  So I set things aside determined to revisit them in time to meet the tax filing deadline.  I learned a few painful lessons.

Self Employment Tax

Tax year 2008 was the first year I had any self employment income to speak of.  It was also my first introduction to the self employment tax.  When you work for an employer, you split the tax rate for social security and Medicare.  But when you are in business for yourself you pay both sides of the equation – 15.3% (12.4% for social security and 2.9% for Medicare).  It may not seem like much, but the self employment tax rate paid on top of your normal income tax rate can make for a large tax liability.

Estimated Tax Payments

Speaking of large tax liabilities, if you plan to have to pay more than $1,000 or so in self employment taxes, it is a good idea to make estimated tax payments on a quarterly basis to avoid underpayment penalties.  Think of this as you withholding from your own income, similar to the way companies withhold tax payments from an employee’s paycheck.

Estimated tax payments may be made free online using the EFTPS (Electronic Federal Tax Payment System).  Once your enroll at the site you are mailed a PIN to the address on record with the IRS.  The pin takes a couple weeks to arrive, so plan accordingly.  Once you have the PIN you may create an online profile/password at EFTPS and you are on your way.

To simplify things a bit, I set aside 30% of my self employment income (freelance writing, ad sales, etc.) in a sinking fund at one of our designated online banks.  When the time comes to make quarterly estimates, I simply transfer money from my “Taxes” sinking fund using the EFTPS.

*Note, 30% may be too high or too low for your specific situation.  It’s a good idea to review last year’s taxes and determine your tax liability for self employment income to come up with a starting amount due for this year.  Be sure to increase or decrease that amount based on your revenues.

Improve Your Record-Keeping System

A good record-keeping system is vital to the success of any entrepreneurial venture.  After all, without tracking profits and losses, how do you even know if what you are doing is worth the effort?  It is also a big help around tax season.  Even if all you do is create a file folder labeled “2009 Taxes” and toss all receipts and income statements there, it’s a start.

Those of us with self employment income have legitimate opportunities to deduct expenses from our income.  For instance, as a blogger I can deduct things like hosting fees, domain registration and renewal costs, graphic design fees, etc.  This is a short list of the many potential tax deductions for bloggers.  Use only those that apply to you, and be sure to keep up with your receipts throughout the year to prove the expenses were paid.

Consider Hiring a Professional

Don’t take my word for it, consider consulting a tax professional, particularly when things get complicated.  A CPA, or someone specializing in taxes for small businesses, will help guide you through filing the appropriate forms, help determine which expenses are deductible from your income, and help you avoid any potential audit red flags.  I am a do-it-yourselfer by nature, but readily admit I will pay for tax advice when necessary.  Considering the consequences of an audit, penalties, etc, it might be the most frugal thing you could do.

Comments

  1. Hey FD,
    I’ve been self-employed for 8 years, and I will say that SE tax is a killer. (I console myself by assuming that employers take their 7% share of SS tax into account and reduce salaries accordingly.)

    The sinking fund is crucial for prepayments; I learned this years too late. Figuring taxes in January and announcing, okay we’ve got to come up with $1500 by April, is not really the best solution. Most software will help you figure how much your prepayments need to be for next year, too.

    And don’t forget about Local and State taxes, if you have them. I’m prepaying three different tax accounts now. Cities are nice though, you can call them pretty easily and ask the accountants all kinds of questions. Even ones like: So if I don’t prepay this 400 bucks before April, are you really gonna come after me? Answer: Well, probably not for that amount.

    TaxAct.com also has free personal software which has worked quite well for my self-employment needs.

  2. I learned so much this year from doing my own taxes. I had 2 schedule C’s, two K-1 ones, and a schedule E rental. Before this year I had known very little about my taxes but after working through my return slowly, including consulting professionals for advice on specific topics, I really feel like I have a good grasp. I would suggest this as a powerful learning tool to anyone who is self-employed.

  3. I am only now becoming entrepreneurial and do not yet have self-employment income, so this question is for a later time. But, if you have a sinking fund that you deposit to on a quarterly basis, why may estimated quarterly payments to the IRS? Why not just keep the money in the checking account earning interest for the entire year right up until tax time on April 15? That way you maximize earned interest on that money.

  4. Our taxes were a nightmare this year with two family members both self-employed. I bought Quicken for Home Business and I have resolved to make it a lot easier on myself next year tracking business expenses. I am going to do better next year after this year’s nightmares ;)

  5. @Su Prieta: If you pay too little in taxes throughout the year, you may be subject to underpayment penalties. I simply pay quarterly to avoid any potential penalties.

  6. Hi! I am self employed (I run an in home daycare.) Before I was self employed I did my own taxes, but now I have a CPA who specializes in home business, especially in home daycare. She is so worth the $250 every year.

  7. Just formed my own S-corp, given my earnings this year are going to be enough to justify the setup and to take advantage of the tax savings. Per your last point, I just hired an accoutant, who for $100 a month takes care of all the payroll and taxes (her fees are tax deductible!)

  8. Good timing on this article FD. I just became part of the unemployed masses and will proabably have to turn to self-employment for a while to make ends meet. Good info.

  9. @DavidK: Sorry to hear about the job loss. Keep me posted on what you get going in the way of self-employment, and let me know if I can help with anything.

  10. Hi FD. Great post. My accountant had to explain the self employment tax to me last year. I’ve had the same accountant for 30 years (he is a family friend) and I feel glad to have him!

  11. Same thing here in Canada – I’m self employed and I have to cover the portion of Canada Pension Plan that an employer would normally match.
    I factor this into my contract rate, though.

  12. FD & Su Prieta,

    What you didn’t mention, FD, is that quarterly payments are integral to avoiding underpayment penalties.

    When you work for someone else, the employers have a fund to sink your Medicare/SS money into. They pay it out once a quarter. So, whether you’re self-employed or not, you essentially pay federal and Medicare/SS taxes once a quarter.

    So if you earn money from SE and don’t pay until the end of the year, your penalty is calculated from the due date of each quarter. In other words, if you should have paid $400 for 4 quarters, you can’t just pay $1600 at the end of the year. The $400 of the first quarter would accrue interest from April 16th – the day it’s paid. The next $400 would earn interest from July 15th – the date its paid. Etc.

    So keeping your money in a fund is a huge risk.

    The one exception is called the “safe harbor” rule. If you paid, during the year, at least as much in taxes as you owed the year before, you won’t be charged a penalty. The IRS assumes you made a good faith effort to pay your due.

    That said, the hardest thing about quarterly taxes is remembering that 15.3% of what you’re paying is Medicare/SS. So if you simply take the amount of money you brought in and pay 25% as a quarterly payment, you’re really paying less than 10% in actual federal taxes.

  13. I’ve been self employed for several years, so I know all too well the joys of the SE tax. Like FD, I set aside 30% of each check, but I put it in a no-penalty savings account which I can easily transfer to my checking each quarter. I’ve never tried it, but I have heard that you can also pay your estimated tax on a monthly basis online. By breaking it down month to month instead of paying every quarter, you can use what I’ve heard the authors Linda Kaplan Thaler and Robin Koval call “The Power of Small” to make paying your taxes a little less painful.

  14. I’ve gone through the SE tax quite a few times. For a part time college student who made less then $12,000 working two jobs (one SE, the other employee… Think the auto industry is bad with layoffs? Try working for a small family business, just trying to put food on the table and gas to get to work), it disturbs me how much I end up paying in taxes each year. Setting aside 30 percent would be nice, if I could. But surviving at this level, coming up with the $1000 “extra” for SE tax at the end of the year is the difference between eating the next two months or paying the government what they “need”. Unfortunately the government is getting theirs first. :(

  15. a few questions for a newbie looks for advice (and i know i can hire an accountant). The situtation – my wife started self employment last November as a part time engineering consulting to one company. She makes roughly $500/month – so when i did the taxes with turbo tax home & business it showed a slight loss with the deductions that were taken. we’ve since filed papers to become a single member LLC and everything went through with mycorporation.com. a few questions:

    -do we need to pay estimated SE taxes? this $6000 estimated income ($500/month) will represent a small fraction (roughly 1/15-1/20th) of our total gross income with my regular job. we typically receive large tax refunds every year ($5-6k).

    -i read about the “safe harbor” rule – where there would be no penalty if you paid at least the amount of taxes you had owed the year before. is that for only the SE taxes or our combined taxes? (if combined – we’d be in the clear since we received a refund – right?). if SE – we didn’t pay any since the Self employment took a small loss since it started in November and the income didn’t cover the deductions – so we’d be in the clear this year to since we didn’t owe any for 2008?

    -if so, i read you don’t need an EIN # for single member LLCs – if so, when you enroll at EFTPS (Electronic Federal Tax Payment System) – do you enroll as a business (they ask for an EIN #) or an individual?

    -if SE payments are needed – what happens if your income significantly increases significantly the 2nd half of the year. do you just change your estimated payments for half way through – would there be any pentalies?

  16. 30% seems pretty high to me. I’ve been self-employed for at least seven years now, and learned the hard way about self employment taxes. In most situations, you “pay” 15.3 percent for SS and Medicare, but you get half of that credited back to reach your adjusted gross income on your 1040 (I’m also a tax preparer). That leaves federal and state income tax. Unless you want a large refund – and you shouldn’t because it gives the Feds an interest-free loan on your money – don’t overwithhold. And don’t forget that the govt. just changed everyone’s withholding requirements so you get to keep a little more.

  17. I have been paying self-employment taxes for over 18 years now. Although I have been a low-income earner I have ben paying them at the same rate as someone with a good job, as self-employment taxes do not distinguish between the poor & the rich.
    In 2008 I had a really bad year. At first I was happy to learn that I was not even required to file a return, as my income was too low; then I saw that because I was self employed, actually I still owed taxes. Even someone who only made $400 the whole year is required to pay self-employment taxes, whereas if I had been working for someone else I could have made up to $8,850 and not owed anything, including Social Security’s cut.
    Does that seem fair to you?

  18. I just finished my first estimated tax payment, and man, that sucks. It’s like 15% for federal taxes, 15.3% for self employment tax and then another 7.05% for my state tax. It’s enough to make me wonder if it’s all worth it! I wish they would just allow me to keep some of my own money! :)

  19. I am an independent contractor for the 1st time, just graduated, I just sent off a payment for the quarterly federal tax due June 15, which was 30% of my net income. What percentage of my net income should I use for California quarterly state tax as self employed? Does anyone know? Thank you for your assistance.

  20. I was layed off end of May and will start working on a contract basis in a few weeks. As I sit here on hold to collect unemployment benefits for the first time in my life, I am wondering what will happen if my contract ends and I have no work. Will the NJ state tax I pay include unemployment insurance? Or do self-employed individuals have no claim to unemployment benefits?

  21. I’m self-employed but not. I work for a foreign consulate on USA territory, but I am an American citizen. Because of this the consulate pays me but does not take out my taxes, this is something I was responsible for, I never received my pin (even after calling and refilling my info several times), and haven’t made a payment the whole of last year. I very frightened about what I owe, and any penalties that are going to accrued on top of that, plus, I live in a state that requires state taxes as well. I don’t know how any of this works, and the consulate is absolutely useless, all the Americans in the office say they just come to expect having to pay now…I just need help and I don’t know who to contact for direction on filing my taxes this year.

  22. Re: Jay

    You should definitely contact a CPA to consult and prepare your taxes this year. You have a complicated situation and a certified public accountant could help you. Just Google CPA (your zip code).

  23. Hello,

    Looking for a little insight as to what business structure would suit me best. I understand that the best advice always comes from CPA’s and tax lawyers, but generally, if I knew that my business would generate a net profit of $30,000-$35,000, would I be better off as a sole proprietor or an S-Corp? Since I will be doing this full-time as my livelihood, the 15.3% SE tax on top of state/fed taxes is very intimidating. I feel like I would be better suited as an S-Corp, but maybe the SE tax isn’t as bad as it sounds when you consider that half of it gets written off.

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