Self-Employment Taxes: What You Need to Know

This guest post comes from Michael, a contributing editor of the Dough Roller, a personal finance and investing blog, and Credit Card Offers IQ, a credit card review site.

Earlier this year, I was fortunate enough to be able to leave my 9-5 job and work on my own as a contractor. Setting my own hours and not having to answer to anyone but myself has certainly proven to be a welcomed change.

But when I recently filed my 2009 tax return, I was hit hard by an unwavering truth: I was subject to pay self-employment taxes.

So just what are self-employment taxes, and are you subject to them?

• If you earn more than $400, you are subject to self-employment tax
• The first $106,800 of your net earnings is taxed for both social security and Medicare. Any additional earnings are subject to the Medicare tax only.

By no means would I consider myself savvy when it comes to the tax department, but year after year of being paid through an employer made me an expert of the 10-minute end-of-year tax return. One W-2, and a few deductions and credits later, I was on my way to a sizable tax refund.

This year, I spent more than 10 times as long preparing my tax return with H&R Block at Home tax software, and I was only contracting for a few months.

Now that I work from home, I am kindly asked by the IRS to pay a self-employment tax. I thought that when I left my office job, I left the days of paying for social security and Medicare behind, but I was sadly mistaken. Not only do I still have to pay those taxes, but I now have to pay twice as much for them!

A total of  12.4% of my net earnings will go toward social security and 2.9% of my net earnings will go toward Medicare. I’m already in the 25% federal income tax bracket, so this means that on paper, 40% of my earnings are going straight to Uncle Sam. That sucks!

To be fair, 40% is a little high because I’m not taking things like deductions, credits, the fact that only a portion of my earnings are taxed at 25% and the rest at 15% and other tax saving methods into consideration.

One of the cool rules of the self-employment tax is that I can deduct half of what I actually pay in self-employment taxes and apply that deduction to my net earnings before I pay the tax, so it’s not as bad as it could be. A quick example for those confused:

If I earned $10,000 in income, I would think that 15.3% of that ($1,530) will be lost to the Self Employment tax. But I can take half of that tax ($765) and deduct it from the original $10,000, leaving me a balance of $9,235. I then apply the 15.3% tax to the new amount, also known as your ?net earnings,? and learn that my actual self-employment tax is $1,413, resulting in a savings of $117. Not anything to write home about, but a savings never the less.

So what do I need to know now that I have to pay self-employment taxes every year?

1. Each year, depending on the number of people I provide my services to, I need to collect Misc-1099 statements at the end of the year to file my taxes. 1099’s are the W-2’s of the contracting world and in order to avoid an audit, I need to make sure I report exactly what is on that form.
2. Now that I started the year as a contractor, I should probably pay quarterly taxes rather than wait until the end of the year. If you think it’s a good idea simply to pay a year’s worth of payroll, federal and state income taxes once a year, think again. The IRS will levy a severe underpayment penalty for holding on to its money the entire year. Payments are to be made April 15th, July 15th, October 15th and January 15th (The January payment will be in the following fiscal year).
3. Owning my own business, I will be keeping my eyes and ears open for every possible deduction to minimize the new taxes that I now need to pay. Previously, the standard deduction was all that I needed but those days are well behind me.
4. Somehow, I need to realize that every check I receive for my work is not 100% mine to keep. A good chunk of that belongs to the government, so in order not to spend everything I make, I’ve decided to set aside an online savings account specifically for payment of IRS taxes. Four times a year, I will take money out of that account to pay my estimated taxes the other days of the year, that account does not exist!

Self-Employment taxes can certainly be a drag if you’re just getting started in a new business and have never heard of them before.

But when you’re 65 and reaping the benefits of social security (reaping may be exaggerated and that’s assuming there’s anything left that far in the future) you won’t be as upset that the IRS made you pay it.

Tagged as: guest post, irs, self employment tax, tax, Taxes