How Much Self Employment Income is Taxable?

Many people are turning to self-employment as another means to make money. Self-employment can come in many forms and can benefit people in a number of ways! However, a lot of people don’t realize that self-employment isn’t just an easy walk in the park. Instead, there are tax implications that individuals need to be aware of before deciding to pursue this path of income. If you don’t get the right education, you may find yourself unprepared when tax time comes around.

Understanding Self-Employment

The Internal Revenue Service’s (IRS) definition of self-employment is the only one that really matters, especially when it comes to the tax side of things. According to the IRS, an individual is self-employed if they meet any of the following conditions:

  • An individual is a sole proprietor or independent contractor of a business or trade
  • A person is a part of a partnership of a business or trade
  • An individual who is in business for themselves or otherwise (including part-time businesses as well)
  • Member or Partner of an LLC.

Pros of Self-Employment

Many people are interested in self-employment for a variety of different reasons. Popular reasons are:

  • Earnings from Self-Employment
  • Work Schedule Flexibility
  • Control of the Work Environment

Earnings from Self-Employment

Many individuals who are self-employed hope to earn a lot of money from this path. For example, if a typical W-2 employee makes $10 an hour and works 40 hours a week then they make $400 a week before taxes. However, a self-employed individual may be able to spend 25 hours a week on making an item that people will buy and earn $850 in a week. In this example, a person working less hours makes almost double the amount of the person working at a traditional job would get.

Work Schedule Flexibility

Another benefit that people like about being self-employed is the work schedule flexibility. For example, if you are an artist that makes paintings, then you could have more work flexibility. If someone commissions you for a project that is due in a month but takes 30 hours to complete, then that means you have 30 days to work just 30 hours. You can divide that time up accordingly which leads to more flexibility!

Control of the Work Environment

When you are self-employed, you can be the deciding factor in the work environment. For example, instead of going to an office to review spreadsheets, you can do it from the comfort of your own home while in casual clothing. This can set the tone for how you dress and act since you decide the work environment.

Cons of Self-Employment

Even though there are some nice perks that come along with choosing self-employment, there are also some drawbacks that people should keep in mind before deciding on this income opportunity. Some cons of self-employment include:

  • Not Enough Income
  • Too Many Work Hours
  • Too Much Stress

Not Enough Income

Even though the hope is to make a lot of money, that doesn’t always happen. If you make hats for bugs, but no one is buying your product, then you earn no income. In fact, you can find yourself still dealing with the costs but with nothing to make it back up. If people depend too much on their self-employment but can’t actually make a consistent liveable income then they can end up in some trouble.

Too Many Work Hours

On the flipside of work flexibility, you may find yourself working too many hours.  A traditional employee will work 40 hours a week. There are a total of 168 hours in a week so only working 40 hours is just a fraction of the time. However, when you are self-employed, you may need to dedicate more time to running the business and handling what you do. Instead of being limited to 40 hours a week you may find yourself working 60, 70, or even over 80 hours a week!

Too Much Stress

When you are self-employed, you are responsible for all aspects of the business. From the marketing department, to the legal department, to human resources, and more, you are the one that deals with everything. It can be stressful to handle all of that, all while providing the service that you intend to provide. People may not accurately account for the stress that they deal with if they run their own business.

Tax Implications of Self-Employment

Taxes aren’t the same for everyone. Your employment situation will impact what taxes you will be responsible for. Individuals that are self-employed can get caught by surprise when tax season comes around. Currently (as of October 2021 when this article was written) the tax rate is 15.3%. This rate comes from the sum of 2 numbers. The rate is 12.4% for Social Security taxes and 2.9% for Medicare taxes. The self-employment tax rate applies to net earnings (also known as profit), not just self-employment income. Every tax situation is unique but it is common for people to pay taxes throughout the year instead of a one-time payment.

Understanding Self-Employment Tax Rate (Social Security and Medicare Taxes)

Many people believe that the self-employment tax rate is just one number but it actually consists of both Social Security taxes and Medicare taxes. Social Security is a program for those that are either at least 62 years old, disabled, blind, or have enough work credits. Medicare is a type of federal health insurance for individuals that are either at least 65 years old, disabled, or have end-stage renal disease.

Individuals that pay self-employment taxes are responsible for the entire 15.3%. This is more expensive for an individual because generally employees split this with their employers. This means they are typically responsible for 7.65% and their employer is responsible for the other 7.65%. Many people do not realize that they will essentially be responsible for handling double the tax rate since they are considered both the employer and the employee when they are self-employed.

Who Has to Pay Self-Employment Tax?

Again, you want to look at the IRS for up to date and accurate information about self-employment tax obligations. According to the IRS, an individual will need to pay self-employment taxes if either of the following conditions apply:

  • A person’s net earnings from self-employment were at least $400 (excluding church employee income).
  • A person had church employee income of at least $108.28

An individual can expect their net-earnings from self-employment to be subject to the tax-rate. The specific tax documentation you get will depend on your actual employment. Many people have the common misconception that tax rules will stop being applicable when they reach a certain age. However, that’s not true! The self-employment tax rules will apply no matter how old an individual is and regardless of whether, or not,  they receive other assistance like Social Security or Medicare.  Please keep in mind that tax laws can change frequently. In order to ensure you are getting the most up to date information, you want to review the IRS website.

How Much Self-Employment Income is Taxable?

The actual amount that you will pay will be based on the amount of money you make. We recommend that you get help from a professional like an accountant. You can find individual accountants or you can get help from a company like H&R Block. Either way, a professional can make sure that the amount you pay to the IRS is correct. However, there are ways that you can calculate your own self-employment tax. It is important that you understand how to do this because you can double check the work of your accountant if you want to ensure even more accuracy!

How to Calculate Your Self-Employment Tax?

In order to calculate your self-employment tax, you will first need to calculate your earnings from self-employment  in order to understand your net earnings. You need to find your net-earnings because that is what the self-employment tax is applicable to. Tips to keep in mind when figuring out your self-employment tax include:

  • First, you will need to figure out your net earnings which is your gross income from self-employment minus your business costs. For example, if your business costs were $100,000 but you made $225,000 then your net earnings would be $125,000.
  • A general rule of thumb is 92.35% of your net earnings from self-employment are eligible for self-employment tax.
  • Now that you know your net-earnings, you can apply the 15.3% tax rate. This means if your net-earnings were $125,000 then 15.3% would go towards taxes which is $19,125.
  • Keep in mind that in 2021 only $142,800 of earnings was subject to the social security portion of self-employment tax. You need to account for that if your earnings were high enough!

How to Pay Self-Employment Taxes?

In order to pay self-employment tax, you can usually use IRS Schedule C to calculate your total net earnings from self-employment. Next, you will use IRS Schedule SE to figure out the amount you owe in self-employment taxes. Information you will need to provide include your:

  • Social Security Number
  • Individual Taxpayer Identification Number (ITIN)

Depending on the tax situation, you can expect to pay them as you go. If you decide to wait until the annual tax deadline then you may face late-payment penalties. Quarterly estimated tax payments can help you avoid those penalties.

For more detailed information about how to pay self-employment tax, you should get in touch with a professional like an accountant. Self-employment taxes can be tricky to figure out, especially on your own.

Overall

The fact that people need to pay more taxes if they are self-employed can catch people by surprise. Instead of being responsible for just 7.65% that is matched by an employer, an individual will be responsible for the whole 15.3%. This rate consists of the rates for both Social Security taxes and Medicare taxes and is only applicable on the self-employment net-earnings. It can be easy to figure out your net-earnings, but in order to be sure that you are properly handling your taxes, you should get the help of a professional.

Commonly Asked Questions

Understanding self-employment tax can feel a bit complicated. Luckily, there are others that may have felt the same way. There are common questions that people have when it comes to dealing with self-employment taxes.

What are Your Self-Employed Tax Responsibilities?

You can expect to be required to pay estimated taxes every quarter as well as file for an annual return. Not only will you be responsible for income tax, but you will be responsible for self-employment tax as well.

Is It Possible to Reduce Your Self-Employment Taxes?

If you want to reduce your self-employment tax, then you will need to claim all available self-employment deductions that you can on Schedule C. This will reduce your net business income which will reduce the amount you owe in self-employment tax. You can get more information about proper forms necessary for self-employment deductions by speaking to a professional or getting information from the IRS website.

Who Receives a 1099-MISC? 

Only independent contractors and sole proprietors will receive this type of form. A 1099-MISC stands for Miscellaneous Income. The payer will fill out this form to report information of payments provided to an individual who is not an employee of over $600 to the IRS.

Article References

https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center

https://www.thebalancesmb.com/what-does-it-mean-to-be-self-employed-398471

https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes

https://www.nerdwallet.com/article/taxes/self-employment-tax

https://tax.thomsonreuters.com/news/social-security-wage-base-increases-to-142800-for-2021/

https://www.mightyrecruiter.com/recruiter-guide/frequently-asked-questions-about-self-employment-taxes/

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