What's Up With Self Employment Tax?

So if you would like to have your question answered in a future podcast episode, please head over to iselerfinancial.com/podcast. The annual income tax filing deadline was just about a month ago now, and I know that lots of people are happy to leave that in the taillights for the next eight to 10 months. But if you like the idea of dialing down the stress around tax filing time, right now is actually the best time to start thinking about and planning for next year's taxes.

Today I wanna share some thoughts on a type of tax that self-employed people have to pay called cleverly enough Self-Employment Tax. Let's start by just clarifying what Self-Employment Tax actually is. When we talk about tax planning, most of the time we mean income tax, the stuff covered when you file your 10 40 with the IRS each year. But there's another type of tax that applies to all earned income which we can broadly call employment tax.

While income tax pays for all kinds of government spending, employment tax pays into exactly two programs, social Security and Medicare. When you have an air quotes, regular W2 job, your employment tax is called FICA, and it's taken out before you get your paycheck.

If you're self-employed though, whether you're a sole proprietor, partner in a partnership, LLC owner, freelancer, or pretty much anybody who receives a 10 99, that tax is called Self-Employment Tax, and it gets paid after you receive your money, typically using quarterly estimated tax payments.

If you use a CPA or software like TurboTax or TaxSlayer to file your annual tax return, chances are that quarterly estimated payment forms for this year were automatically generated as part of last year's filing. It is important to note that employment tax is always split evenly between employer and employee, but when you work for yourself, you fill both of those roles, which means you're stuck paying for both sides of the equation.

The upside is that the employer half counts as a deduction for income tax purposes, and the downside is that you still have to pay it. I wanna restate a few of those points just to avoid confusion. Self-Employment Tax is not an extra tax that specifically targets self-employed people. Instead, it's a replacement for FICA that W2 workers have automatically deducted from every paycheck. Okay? So it's functionally the same thing as FICA.

But because self-employed people are both employer and employee, they're stuck paying the whole thing. The actual calculation for Self-Employment Tax is kind of complicated, but it works out to about 14.13% of net business profit. For contrast, fICA is 15.3% of earned income. So Self-Employment Tax actually works out to be slightly less than FICA. But again, when you are your own boss, you're stuck paying both halves. Are you with me so far?

So when you have a W2 job, your employer takes a slice of business income and uses that slice to pay you. That means that some of the business profits gets treated as compensation, and FICA is owed on all of that compensation, and the rest of the business profits are not treated as compensation for tax purposes. But when you're self-employed, all of your business profits are treated as compensation.

That means that Self-Employment Tax is owed on all net profits, regardless of whether you internally in your own bookkeeping, treat that as compensation or use that money to pay yourself. I wanna underscore this because it's a point that's often misunderstood. If you are self-employed and have business profits, the whole thing is treated as earned income for tax purposes, even if that money sits in a separate business bank account and never hits your personal bank account. Does that make sense?

The IRS does not let you treat only part of your profits as compensation, if you are a sole proprietor, partner at a partnership LLC member or freelancer. So here's a simple example. Let's say you're a freelancer and you earn about 80 K in gross 10 99 income. And let's say that you spend around 30,000 per year on business expenses like office supplies, rent, software, equipment, et cetera, et cetera.

That means your net business profit is therefore 50 K, 80 K minus 30 K equals 50 k, and Self-Employment Tax is calculated based on that number, not the gross number, but that net profit number. And again, that's true even if the money stays in a business account and never gets transferred to a personal bank account. A couple of notes. The amount you pay in employment tax does not reduce the amount you have to declare for income tax purposes.

That's true for W2 employees and also for self-employed people. Okay, so paying employment tax does not reduce your taxable income for your annual filing purposes. Also, even though contributing to accounts like IRAs 4 0 1 Ks or SEP IRAs can reduce the taxable income on your annual 10 40 filing, it does not reduce the amount you owe in employment taxes. Again, that's true whether you get a W2 or a 10 99.

Okay, since Self-Employment Tax is calculated on net self-employed profit, the only way to control how much tax you pay is to control your profits. Higher expenses means lower net income, and lower net income means less Self-Employment Tax. That makes sense, right? I know lots of self-employed people who bend over backwards to find things to write off to reduce their taxable income, and there is absolutely nothing wrong with taking advantage of tax code rules to minimize the taxes you pay.

That's how our system works in the US and you're entitled to take advantage of those rules. But there can be downsides to, let's call it very aggressive deductions. One downside is that in the enthusiasm to find more deductible expenses, some self-employed people actually end up spending a lot more than planned so that they can lump those purchases in as business expenses. Like, "I made a lot of extra money this year, so I better buy a bunch of stuff so I can write it off."

While it's true that spending an extra 5K in business purchases will reduce your taxable income by 5K, that's true. It's also true that you no longer have that money. So you save on taxes, but often you may end up with less money in your pocket at the end of the year. I don't necessarily see that as a win. Sometimes I think that keeping more of your money for yourself and accepting the tax impact is a better trade. But that's just me and how I see the world.

I would rather keep more of my money, even if it means paying some taxes. The other downside of self-employed people writing off a ton of expenses to reduce taxable income is that you're also reducing your access to what Self-Employment Tax actually pays for: Namely Social Security and Medicare. So while everybody likes paying less in taxes, please keep in mind that reducing your Self-Employment Tax also reduces the benefits you will receive from Social Security and Medicare.

And unfortunately, lots of self-employed people just don't have a great plan when it comes to saving for retirement. So those benefits will actually end up being super important to a lot of self-employed people. If you're really aggressive in finding business expenses to write off, you may pay less in current year taxes, but you'll also be shortchanging yourself in retirement in the form of lower Social security retirement benefits or higher health insurance costs.

Okay. Tons of details in there on kind of a dry topic, but here are the key takeaways: self-Employment Tax serves the exact same purpose as FICA. It's not an extra tax on self-employed people. Instead, it's a replacement for the tax that traditionally- employed People pay. When you're self-employed, you pay both the employer and employee halves of employment tax. The employer half counts as a deduction for income tax purposes, but you still have to pay it.

If you're sole proprietor, partner in a partnership, LLC member, or freelancer, the only way to reduce Self-Employment Tax is to reduce net profits. And finally, while everyone loves saving on the ol' income tax bill, sometimes writing off a bunch of expenses means less money in your pocket now and less access to Social security and Medicare benefits later. All right.

There is one additional way that self-employed people can reduce employment tax, which is more complicated, but allows you to designate a portion of your business profits as compensation and avoid employment tax on the rest. That's right, i'm talking about the S corp election. I'll discuss the difference between LLCs and S Corps in two weeks, which is an important but often confusing topic for self-employed people.

And next week I'll be back with a conversation with musician, author and teacher Franz Nikolay. I read his new book called Band People subtitle, life and Work in Popular Music, and found a ton of crossover between the topics he covered in the book and the stuff I think about all the time. Okay, that's it for today. Now it's time for some disclosures. The thing we never talk about is for educational and entertainment purposes only. It's not legal, investment or tax advice.

People on the show, including yours, truly may have interests for or against any investments discussed. So do yourself a favor and don't make any decisions based on what you hear on this or any other podcast. If you have a money or finance question you'd like answered in a future episode, please visit iselerfinancial.com/podcast. Again, that's iselerfinancial.com/podcast, and Iseler is spelled I-S-E-L-E-R.

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