As a person who was formerly self-employed — and who still freelances — I know the sting of self-employment tax intimately.
Every time I get a check in the mail, my delight turns to despair when I have to give basically one-third of it to the U.S. government.
What is self-employment tax?
When you work for a company, taxes are taken directly out of your paycheck. But when you work for yourself, you get the whole amount.
Although it feels snazzy for about four seconds, you still need to pay taxes on that money. And the first time you calculate them, you might be shocked by the amount.
Here’s the deal: Everyone pays 6.2 percent of their income toward Social Security and 1.45 percent toward Medicare, for a total of 7.65 percent of each paycheck. When you work for somebody else, your employer matches that amount, for a total of 15.3 percent of your gross income.
But when you’re self-employed, you’re responsible for that other half yourself — doubling the percentage you owe toward Social Security and Medicare.
That’s a hard pill to swallow, but there are two deductions that soften the blow:
- You have to pay self-employment tax on only 92.35 percent of your income (because the 7.65 percent your employer would’ve paid is deducted). So, if you earned $100,000 in one year, you’d pay self-employment tax on only $92,350.
- You also can deduct half the amount of self-employment tax you pay. If you paid $10,000 in self-employment tax, for example, you could deduct $5,000 from your total taxable income, which — although it won’t save you on the self-employment taxes themselves — could put you in a lower tax bracket.
Who needs to pay self-employment tax?
If you earn more than $400 per year working a gig that doesn’t take taxes out of your paycheck — independent contractor, freelancer, #girlboss, babysitter, etc. — you owe the government self-employment tax.
And if you anticipate owing more than $1,000 in taxes, you shouldn’t wait until April to pay them (or you might face fees). Instead, you should file estimated quarterly taxes.
“I would always recommend paying your estimated taxes,” said Eric J. Nisall, an accountant who specializes in taxes for freelancers. “It’s always easier to make four payments than one lump payment … and then you don’t need to pay underpayment penalties.”
One exception to self-employment tax occurs when you earn more than $127,200 in a year: You don’t pay Social Security taxes on any income above that amount. And that’s total income — so if you earn $125,000 from your day job and $25,000 from your side hustle (a girl can dream, right?), you’ll pay Social Security taxes on only $2,200 of your side hustle earnings.
5 tips for saving money on self-employment tax
Although there aren’t many ways to save money on self-employment tax, here are a few tricks you might not have discovered yet.
1. Invest in your business
One of the best ways to reduce your tax burden is to reduce your taxable income. And one way to do that is by claiming deductions for small business expenses.
That being said, you shouldn’t purchase things simply because doing so will save you money on taxes. Nisall called this move one of his “pet peeves.”
“If you’re spending $100 to save $20 in taxes and you don’t necessarily need that item, you’re wasting $80,” he said. “Sometimes it’s better to not spend the money … and pay a little extra in taxes.”
Instead, he suggested smart investments like paying for a designer to improve your website, for a photographer to take professional headshots, or for ads on social media.
“That will reduce your taxable income and, in turn, reduce your self-employment taxes — but you’re not just throwing the money away,” he said. “You’re helping to grow the business.”
2. Contribute to retirement
When you’re self-employed, you’re the only person you can rely on for retirement.
One way to help yourself now — and in the future — is by contributing to a retirement plan. With the plans below, your contributions will be deducted from your taxable income and therefore lower your tax burden.
Here are the annual contribution limits for different retirement accounts in 2017:
- Traditional IRA: $5,500
- SEP IRA: 25 percent of net income or $54,000, whichever is lower
- Solo 401(k): $18,500 plus 25 percent of net income, for a maximum of $54,000
3. Consider advertising with a charity
If you’re like me, you don’t donate enough money to charities to itemize your tax return. You simply claim the standard deduction of $6,350 — which means your charitable donations don’t benefit your financial situation whatsoever.
For self-employed people, one workaround is to advertise with a charity. By, say, sponsoring an event or taking out an ad in its newsletter, you’ll support the charity — and you can claim the cost as an advertising expense.
4. Claim all your deductions
I know; I’ve been talking about deductions a lot. But reducing your taxable income is basically the only way to lower the amount of money you’ll pay in self-employment taxes.
- Home office: If you have a dedicated home office, you can write it off.
- Conferences: Schmoozing counts too.
- Online courses: If what you’re learning relates to your business, deduct it.
- Supplies: From business cards to website hosting fees, include everything you need to run your business.
- Mileage: Keep a record of where you go for work, and you can deduct 53.5 cents per mile driven.
Nisall said some of the most overlooked deductions surround credit cards. When it comes to business credit cards, interest, annual fees, and late fees are all tax-deductible. That’s why it’s so important to keep track of everything.
“More of an issue than forgetting to deduct stuff is forgetting to track things properly,” said Nisall. “Make sure you’re using a separate card or a separate bank account; that way, everything that goes through there is directly related to the business.”
5. Get professional help
If the financial part of your business seems overwhelming, don’t hesitate to get professional help. Hiring an accountant can often lead to new deductions as well as an error-free return.
“It’s worth paying a couple hundred dollars to have someone back you up and tell you ‘yes, you’re right’ or ‘no, you’re wrong’ [and avoid] getting a dreaded letter from the IRS,” explained Nisall.
And the best part? That accounting or tax preparation fee can be — you guessed it — tax-deductible.
Self-employment tax isn’t fun, and it can be one of the most difficult parts of launching a side gig or new business. But by staying on top of your finances and educating yourself, you’ll make the process as painless as possible.