When we talk about tax planning, most of the time we mean income tax – the stuff covered when you file your 1040 with the IRS each year. But there's another important type of tax that applies to all earned income: employment tax. While income tax pays for all kinds of government spending, employment tax pays to fund exactly two programs: Social Security and Medicare.
Employment tax is always split evenly between employer and employee. When you have a "regular" W-2 job, the employment tax is called FICA and it's taken out before you get paid. If you are self-employed, though – whether you're a sole proprietor, freelancer, LLC owner, or pretty much anyone who receives a 1099 – that tax is called (cleverly enough) Self-Employment Tax and it gets calculated based on net business profit.
Here's an example: let's say that you're a freelancer earning $100,000 in gross 1099 income. Let's also say that you spend around $36,000 per year ($3,000 per month) on business expenses like office supplies, rent, software subscriptions, equipment, etc. Your net profit is therefore $64,000 and Self-Employment tax is calculated based on that number, not the $100k gross income. The actual calculation for S-E Tax is kind of complicated, but a shortcut is 14.13% of net income, with 7.065% paid by you as employer and 7.065% paid as employee. So in this example, you would owe $9,043.20 in Self-Employment Tax ($64,000 x 0.1413 = $9,043.20). While you're stuck paying both employer & employee halves of S-E Tax, the upside is that you get to deduct the employer half ($4,521.60 in this example) on your Schedule 1 when you file income taxes.
When you're a W-2 employee, you basically pay FICA on all wages. But, since Self-Employment tax is calculated on net business profit, there is some flexibility when it comes to how much tax you pay. (Higher expenses means lower net income, and lower net income means less Self-Employment Tax.) While everyone likes paying less in taxes, please keep in mind that reducing your Self-Employment Tax also reduces the benefits you will receive from Social Security and Medicare. If you're very aggressive in finding business expenses to write off, you may pay less in current year taxes – but you'll also be shortchanging yourself in retirement in the form of lower Social Security retirement benefits or higher health insurance costs.
A couple of important notes: the amount you pay in employment tax does not reduce the amount you have to declare for income tax purposes – even if that money never hits your pocket. Also, while contributing to accounts like Traditional IRAs, 401(k)s, or SEP IRAs can reduce the taxable income on your annual 1040, it does not reduce the amount you owe in employment taxes.
Have any questions about how your self-employed income impacts your taxes? Feel free to email, sign up for weekly Office Hours, or schedule a one-on-one meeting.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify your current strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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