Paying Self-Employment Tax Hurts, But is Better Than Wages.

When that 1099 comes in the mail many don't understand how different their tax situation will be until starting the tax preparation process. Here's a quick guide to what Self-Employment (SE) tax is, and how this is different, and not really such a bad thing as it seems at first glance.

Understanding Self-Employment Tax...

What is self-employment tax?

Self-employment (SE) tax is the Social Security and Medicare taxes due on your income, totaling a sometimes painful 15.3% of your net income. When you work for an employer who pays you regular wages the employer withholds these amounts out of your paycheck and pays them directly to the Social Security administration. As they are withheld from each check it is less obvious that you are paying these amounts.

But the amount I owe now seems so much higher?

This is because when you work for an employer they pay half of your Social Security and Medicare costs and this is never listed on your paycheck, so in essence it is a "hidden" tax. If your employer changes you from being a W-2 employee to a 1099 independent contractor, it is the equivalent of getting a 7.65% pay cut.

What is the upside?

As an employee you are very limited to what expenses you can deduct against your income, and they all go in as part of your itemized deductions after being reduced by 2% of your gross income. When you are an independent contractor you can deduct all the expenses you have against your gross income before you pay income or SE tax, often lowering your tax amounts substantially.

Can you give an example?

Let's say you are single and make $50,000 a year, using 2014 amounts, you will as an employee pay $5,935 per year as income tax and $3,825 as Social Security and Medicare taxes for a total paid of $9,760. If you earn that same $50,000 but as an independent contractor and you qualify for having a home office, auto expenses, and various other deductions that total $20,000, your regular income tax will be $2,235 and your self-employment tax will be $4,239, totaling $6,474 total tax paid. This adds up to a savings of $3,286 for being paid as an independent contractor.

What if I don't have any business expenses?

From experience, the vast majority of taxpayers have business expenses, and many they do not think about. We have a number of success checklists here that detail out various expenses we have seen clients forget in the past. However, if you really don't have any business expenses as your company pays for everything, then you are much better off to be paid as an employee.

Why didn't my credits and deductions reduce my SE tax?

Tax preparation is made up of two parts- the laws that get voted in by Congress and how they were applied by the IRS. Often a tax or credit is less important in and of itself than where it comes in on the tax return. SE tax is unusual in that it comes in near the very end of the tax return, therefore only refundable credits such as Child Tax Credit, Earned Income Tax Credit, and American Opportunity Tax Credit, are available to offset it. All of the standard credits reduce income before where the SE tax comes into the tax return. Therefore you can have credits that never even get applied, but still end up with a balance due.

Should I make estimated payments?

If you are going to end up with a balance due at the end of the year it is recommended you make estimated payments that will prevent you from owing penalties the following year. You have the choice with paying estimates of either 100% of the current year taxes or 90% of the estimated amount of the following year's taxes. Typically it is best to just pay the 100% of the current year, but if you know the next year's taxes will decrease then it can be based on that. You will need to make payments of one quarter of the amount on April 15th, June 15th, September 15th and January 15th for them to be timely. Payments can be made on the IRS website here.

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