As an employee, your employer will deduct the necessary Social Security and Medicare taxes from your paycheck. However, if you run your own business, then you must do this yourself. This is done by filling out Schedule SE, which will compute your self-employment taxes (the amount is reported on the “Other Taxes” section of your 1040). Although, you will owe nothing if your net earnings are less than $400 for the year.
The self-employment tax includes the following:
- 12.4% rate for Social Security: This is for up to $118,500 in net earnings.
- 2.9% rate for Medicare: Unlike the Social Security tax, there is no cap. You must pay the 2.9% on all your net earnings. There is also an additional 0.9% tax for high-income earners.
Keep in mind that you are allowed to reduce your net earnings by 50% for the calculation of the self-employment tax and you also get to deduct 50% of the self-employment tax on your 1040.
Ok, so here’s how it works: Suppose that you generate $50,000 in net earnings for your business. In this case, only $46,175 is used in calculating the self-employment tax, which comes to $7,065.
Then, you can deduct $3,532 on your tax return, which reduces your adjusted gross income and yes, the amount you will ultimately pay taxes on.
Note: You may want to consider making estimated quarterly tax payments, which should avoid having to be subject to penalties and interest.