There are plenty of benefits to being self-employed that can be found in business books and on the internet. The ability to work from home, to make your own schedule, and to be your own boss are at the top of those lists. We love working with self-employed entrepreneurs, but all too often decisions to make an employment change are made without considering the tax implications. It is prudent to know all the facts before making the career and lifestyle change of becoming self-employed. Beyond the loss of employer provided benefits like health insurance and a retirement plan, one of the major differences for tax purposes is self-employment tax.
What is self-employment tax?
As an employee, Social Security and Medicare taxes are being withheld from your pay (whether you are aware of it or not) in additional to Federal and state income taxes. The percentages withheld under the current law are 6.2% for Social Security and 1.45% for Medicare. What you also may not realize is that your employer is required to match or pay in the same amount on your behalf. This means that a total of 15.3% in Social Security and Medicare taxes are being remitted to the government by your employer. As a self-employed individual you are both the employer and the employee of your own business so you will be required to pay in the entire 15.3% as a separate tax. The maximum amount of income subject to the Social Security tax in 2014 is $117,000.
How does self-employment tax work?
Self-employment tax is calculated on the individual income tax return at the end of the year and is an additional tax on top of Federal and state income taxes. Some clients come to us having heard to plan on giving 1/3 of their net earnings to taxes at the end of the year. Unfortunately this is not a bad estimate and depending on the household income mix can be an even higher percentage. Self-employment tax is assessed on 92.35% of net business income from your business. Net business income means gross income earned less all allowed expenses. This is the silver lining of being self-employed for tax purposes. Any and all out of pocket expenses incurred by being self-employed are deductible against income. This can include office supplies, equipment, home office expenses, mileage, etc.
Is there any good news?
Of course! As mentioned above the perk of being self-employed (in addition to the lifestyle benefits) is that all expenses incurred are deductible against gross business income. Health insurance payments for self-employed individuals as well as pre-tax retirement contributions are deductible as well. Also, there are tax planning strategies to help minimize self-employment tax once the business makes enough net business income to do so. S Corporation elections are weekly conversations in our office and if you are planning on being self-employed full time that discussion should happen sooner rather than later. The best thing for self-employed individuals to do is to be proactive. Know the tax implications of being self-employed, be sure to plan for higher income goals to accommodate for these taxes, and make estimated tax payments throughout the year to help reduce tax surprises at the end of the year. Being self-employed is at the top of my list as reasons to consult a CPA, so feel free to do so and as always we are here to help!