Self Employed Taxes for Dummies
Have you ever thought to yourself "man, I just love paying taxes"? If you are the average American I'm going to assume that the answer to the aforementioned question is "no". It seems as though the words "income tax" should be classified as a bad language from the way that people try to avoid paying 1099 taxes it like the plague, or should I say COVID-19 (2020 problems)?
Unfortunately, Uncle Sam is inevitable and you can try to equip yourself with as many masks, gloves, hand sanitizers, and most importantly, toilet paper as possible but even that won't prevent the evil IRS from laying its grubby fingers on your hard-earned cash. Luckily though with adept knowledge of different portions of the tax code you can save some well-deserved money you've made via a 1099-MISC or freelancer income! Here is the self-employed taxes for dummies guide. Now before I go all CPA on you I think it's worth a minute of your time to know how self-employment tax came into existence.
Income Tax in America
While I'm no Nicholas Cage in National Treasure I know just enough to get you a solid enough background to at least impress the next person you take out on a date. Because let's face it, everyone absolutely loves hearing about taxation, that's why CPA's have earned the stereotype for being such interesting people.
Anyways, I digress. The American income tax system has evolved since the inception of the country. Think long and hard about your fifth-grade history class. Remember the Boston Tea Party? One of the first groups of American's who wanted to stick it to the man and keep their tax dollars to themselves.
So remember, you definitely aren't the first American to complain about your taxes, and you certainly won't be the last. There weren't really income taxes up until the 1860s. The first personal federal income tax was passed to help pay for the war effort. It was repealed about ten years later, only to be brought back eventually in the early 1900s, largely in part to help finance another war. World peace sounds even better now right? Ever since then the personal federal income tax has been here to stay, and get much more complicated! That is a quick background on the personal income tax, but as we know there are many other types of taxes. We will focus on payroll taxes and self-employment tax going forward in the article.
Payroll Taxes - Social Security Tax
Probably the next monumental tax after the personal federal income tax that was passed was in 1935 when Social Security was introduced. The idea of social security was well received at the time since this was just after The Great Depression and many people saw their ideas for retirement go down the drain by losing their jobs and life savings. And let's face it, not everyone back in the day was a Russell Crowe Cinderella Man and could literally fight their way out of the situation. There was a wide consensus that this was a good thing, but as all great government ideas come about there is a question that comes along with it: "well how do we pay for it?"
Not a lot of people were making money, thus their tax bills were low, and personal income tax revenues were down. However, jobs were coming back, so then began something that no one has grown to love: payroll taxes. If you have ever received a W2 before you should be semi-familiar with what payroll taxes are. I mean, why just take it from your overall income once a tax year at tax time when they can take it immediately from your paycheck? Literally what happens is that for every dollar you are paid a portion of it is taken out in the form of a payroll tax.
In addition, the amount you pay to your employer also matches that portion. So if you had a payroll tax liability of $5 for a given paycheck, your employer would match that $5, and the IRS would get $10 in total. Not a bad deal for the IRS right? So that is how the social security tax started. Since its inception, the social security tax percentage has been raised a couple of times, in addition to the social security wage cap. What the wage cap does is that if you earn over a certain amount one year any amount over the cap is not subject to social security tax.
The cap shortly after the tax was passed was around $3,000. It is currently at about $133,000. The tax rate for social security now sits at a plump 6.2% on every dollar of earned income. I know this is a lot of boring information but I PROMISE it is going to tie in later.
Payroll Taxes - Medicare Tax
What do you get when you combine a human race that is living longer, rising medical costs, and grandma and grandpa visiting the doctor for every new bunion that pops up? Taxes. Yes, a brand new tax, and even better, a payroll tax that immediately comes out of your paycheck! Exciting right? Medicare tax came about in 1966 when the aforementioned happened. Insurance plans also became more and more linked to employment groups (business entities) and it became increasingly difficult for people who have been around the block a few times to get good health insurance coverage. Take what we just learned about social security tax.
It's a payroll tax, so it comes out of your paycheck. The employers also match what you pay in, so for every dollar paid to an employee the IRS gets money from both sides, the employee and the employer. Unlike social security tax there is no cap on your taxable earnings, so if you got a gig as Jeff Bezos assistant as he continues to attempt to take over the world and he paid you one billion dollars a year, your social security tax liability would stop accruing in about your first twenty minutes of work during the year after you earn $133,000. However, you will be paying Medicare tax on all one billion dollars worth of your wages. It helps that your Medicare tax rate is lower than the Social Security tax rate at 1.45% of gross wages. Now that you have a good understanding of payroll taxes we can get down to the nitty-gritty: self-employment tax.
Self Employment Tax
After reading the last two paragraphs you are probably wondering why the heck I am lecturing you on payroll taxes when all of you reading my article isn't on the payroll. You guys are the hardcore freelancers. The sole proprietors. Small business owners. There isn't any space in your personal finance plans that is reserved for payroll taxes because you don't pay yourself. You have broken free from the antiquated ideals of eight hours a day, five days of the week. You are earners of your own money and are working on scaling your business. I get it. However, the IRS doesn't seem to get it. All they seem to get is that they want a portion of your net income every year and they are going to get it no matter what. And they hit sole proprietors, freelancers, and small business owners pretty hard with self-employment tax. Don't forget you'll have to pay estimated taxes four times a year instead of one lump sum. Here is more info on when your quarterly taxes are due.
Self-employment tax is a tax on the net income of a self-employed individual. This tax is a huge 15.3% of your net income for the year. As if that wasn't bad enough, this is also not including what you have to pay based on your marginal tax bracket. So say that you are in the bottom income bracket, the 10% bracket. Any dollar you make from self-employment results in a tax bill of 25.3%, yes, ONE-FOURTH of your net income. I know what you are thinking. "Are you serious?! How is that fair?!" To be reader-friendly I removed the expletive language from that phrase.
Yes, you are a small businessman/woman. You are the lifeblood of the modern US economy. Why are you getting shafted by the IRS when there are plenty of other filers they could hit for some of that money? Well, let's dig a little deeper before we start pointing fingers. The self-employment tax rate is 15.3% on net earnings from self-employment. Remember, net earnings means your total business income/revenues less your total business expenses. What do we remember from payroll taxes? There are two primary payroll taxes: Social Security Tax and Medicare Tax. Social Security Tax is 6.2% of each dollar that someone is paid. Medicare Tax is 1.45% of each dollar that someone is paid. In addition to these amounts, the company paying the employees to match the employee contribution. So with the additional skills, we all learned in second-grade math let's add up these percentages.
The amount comes to 7.65% of gross income/wages that employees pay and 7.65% of wages that the employer pays. If you add these two together what do you get? The self-employment tax rate of 15.3%. Essentially, the IRS sees you as being self-employed, so you are acting like a company that is employing yourself. Any net income that you have then will be taxed as if you were paying yourself everything that your business is generating, since if you were doing this for someone else the amount of income you are generating for yourself is likely what you would get paid somewhere else. This is how they get small business owners to contribute their share of Social Security and Medicare tax liability. So while still being absolutely ruthless and evil, the IRS does have some sort of basis to charge self-employment tax. Use this free self-employment tax calculator to see how much you'll owe in taxes.
Now the most important question comes to life: how do I minimize this tax?
How to Minimize Self Employment Tax
As we remember from the beginning of the article no normal person loves funding Uncle Sam's bottomless wallet. Us as taxpayers want to keep as much in our pockets as possible. Since self-employment tax is such a staggering rate it is good to remember what you can do in order to reduce that liability to yourself. Being an independent contractor or a freelancer you will likely report your business income and business expenses on Form Schedule C.
It's incredibly important that you include all business expenses that are deductible, AKA tax deductions. This just requires a tiny bit of knowledge about what exactly is deductible or having an awesome company like Keeper Tax take control of your books for you and identify potential 1099 deductions you could possibly take. Other deductions to remember for your tax return could be recommended by other tax professionals, like the home office deduction.
To illustrate how much this could save you just imagine if you found $10,000 worth of deductions that you weren't initially taken. Just in self-employment tax savings, you would be looking at an immediate $1,530 in savings. Just imagine how much toilet paper you could buy with that (COVID wouldn't stand a chance against you)! Really doing your homework and understanding what you can and can't deduct could save you thousands of dollars in self-employment tax and personal income tax. I highly encourage you to take advantage of some of the other Keeper Tax's free resources, getting in touch with them about doing your business books, or contacting a tax professional in order to make sure you are getting the deductions you deserve. Check out our independent contractor tax guide for more information.
Remember, there are some things you just can't flat out avoid. The year 2020. Rick Astley's music video Never Gonna Give You Up. Taxes. Death. Sooner or later you are going to get hit with one of these things. The good news is that with proper planning we can minimize the impact of at least one of those and keep some extra money in your pocket. If you have any further questions about your business code or taxes, I advise you to seek out a tax professional for additional guidance.