Previously, we looked at self-employment taxes in our TACO (Taxes, Accounting, and COvering your risks) article, and here we'll give a little more background information about how the system works.
We strongly recommend that you pay for a professional tax preparer or service when you're self-employed, because there are new forms and rules and the tax laws change frequently, and every person's tax situation is unique.
For now, let's back up and answer some of the most common questions that beginners have. That way you'll be better prepared to take control of your own tax situation now and in the coming years.
What are self-employment taxes?
A lot of people confuse self-employment taxes with "regular" taxes or think one replaces the other. Here’s how it actually works:
1. You have to pay the same federal income tax as everyone else.
When you’re self-employed you pay the same income tax as someone who earns a wage working for an employer, and it’s usually between 10-25% of your income depending on how much you earned. But keep in mind that since there’s no employer to automatically withhold this tax with each paycheck, you’ll need to set aside the money yourself.
2. The "self-employment tax" replaces the Social Security and Medicare taxes that wage earners and employers pay throughout the year.
If you’ve ever received a W-2 form from an employer, you may have noticed two dollar amounts in boxes 4 and 6. These are taxes specifically set aside for Social Security and Medicare. In 2016, the self-employment tax rate is 15.3% on the first $118,500 of your net income and 2.9% on income exceeding $118,500.
Here’s the wrinkle for people who are self-employed, and why you hear freelancers complain about having to pay extra. When you're a wage earner your employer pays half of these taxes—but since you are your own employer, you get stuck with the entire bill.
This works out to an extra 7.65% tax (the employer half of 15.3%) that you have to pay that wage earners don't. Consider it the cost of being your own boss.
How do I know if I need to pay this self-employment tax?
As we mentioned above, you have to pay federal income tax on all income, regardless of how you earned it. But you might be exempt from the self-employment tax if your net income is low enough.
Here’s how to determine your exemption status:
- Add up all of your self-employed income for the year.
- Subtract your business expenses (the cost of running your business).
- If the remainder is less than $400, you don’t owe the self-employment tax.
For more information:
Self-Employment Tax (Social Security and Medicare Taxes) @ IRS.gov
What do I use in place of a W-2 form?
We can’t tell you all the forms you’ll need to fill out for your specific situation, but let’s address this common beginner’s question, which is what to use in place of a W-2 form.
Most people who file taxes are familiar with the W-2 because it’s the form your employer provides that you then attach to your tax return.
There’s a similar form that self-employed tax filers use called a 1099-MISC form, but unlike the W-2 it doesn’t need to be attached to your return because the IRS will already have a copy on file.
Anyone who paid you during the year can send you a 1099-MISC, and they are required to if they paid you $600 or more. If for some reason they don’t, you still need to report the income to the IRS. This is why it’s so important to keep track of all of your income for the year.
For more information:
Form 1099-MISC, Miscellaneous Income @ IRS.gov
When do I need to file?
When you’re self-employed, the IRS will expect you to pay your estimated taxes quarterly, then file the traditional annual return where you’ll square your actual tax payment with what you’ve already paid (or overpaid).
You might be able to avoid this extra work if you don't make much money. The IRS says that if you expect to owe less than $1,000 in taxes for the entire year, you might not have to pay quarterly estimated taxes.
For more information:
Self-Employed Individuals Tax Center @ IRS.gov
Estimated Taxes @ IRS.gov
Where can I go for more help?
If you're self-employed and looking for more help with your finances, we've got a guide to setting up your own benefits program here. Below are some good places to look for more answers about your taxes.
Photo: Liz West