How Will Self-Employment Tax Affect My Personal Tax Return?
Most folks begin their first job working for someone else and being paid wages. As an employee, taxes such as FICA, Medicare, and federal income tax (FIT) are withheld from the paycheck by the employer.
When you become self-employed, you take on the responsibility of calculating and remitting those taxes to the government. Nothing is withheld on your behalf. When you get paid $1,000.00, you get the $1,000.00. You must calculate the "self-employment tax" and determine the appropriate amount of FIT to set aside.
You pay these taxes to the government by paying estimated tax payments during the year. (see Individual Tax).
The issue that takes many newly self-employed people by surprise is that when you have net income from self-employment, that is, actual positive net income, you are going to owe some tax independent of whether you owe FIT. This is because the self-employment tax, the FICA/Medicare (calculated at ~15% of net SE income), is included in the determination of your personal income tax after all other loss offsets, personal exemption deductions, itemized deductions, and tax credits. See the following flow chart which shows the net income from self-employment flowing into your other sources of income for determination of FIT and this same net income generating self-employment tax that enters your tax return with "Other Taxes" such as the penalty from the early withdrawal from a retirement account.
Understand that this "self-employment tax" is not a penalty for being self-employed.
Rather, the ~15% rate comes from your having to pay "both sides" of the FICA/Medicare. As you recall when you were working for an employer and taxes were taken out of your paycheck, what was taken out of your paycheck was your employee portion of the FICA/Medicare at ~7.65%, and, of course, FIT (federal income tax withholding). Your employer also paid ~7.65% to the government, which is a portion of the employer's expense of payroll. This is the other half of what makes up the ~15%. Once you become self-employed, you are the employer. You now have to pay both sides of the FICA/Medicare. Therefore your total taxes increase by ~7.65%, only ~7.65%. Your income tax does not change. You do receive a deduction of ~55% of the self employment tax toward the determination of your income tax which does somewhat mitigate the impact of the additional ~7.65%.
This situation of your having the responsibility of paying the taxes, all of the taxes, of your setting aside the funds to pay those taxes, often, at least initially, can lead to cash flow problems if you do not prepare yourself to pay those taxes. This is where the problem often arises. This is really a psychological issue. When you receive a net paycheck from an employer, you can spend that money with the understanding that your taxes have been taken care of (with the understanding that you may or may not have had enough FIT withheld). When you receive a check for the entire amount of your payment for your services, the tendency is.....to spend the whole amount. The intention of course, is to set aside the appropriate amount for those taxes. But if that set aside is not made, the postponement of paying those taxes compounds with each check and the eventual "true up" of taxes at tax return time can be significant.
And, heads-up, in addition to determining your taxes and setting aside the funds to pay them, as a self-employed person, you become responsible for your own health care insurance and your own retirement plan.
The lesson is, understand the responsibility of being self-employed and discipline yourself to make those estimated tax payments and plan for your health and financial future.
If, after reviewing the following flow-chart, you have any questions, or, if you need assistance in calculating your taxes and making estimated tax payments, please contact us.
