Taxes as an employee is pretty straight forward. You get taxes withheld from your paycheck and at the end of the year your employer provides you with a W-2. Things are a little different when you’re self employed. We’ll simplify and explain the differences so if, or when, you become self-employed you will know what to expect.
You are self employed person if you do business as an independent contractor or sole proprietor or are a partner in a partnership. You are also considered if you have your own business and form an LLC for that business.
Social Security and Medicare When Self Employed
Social Security started back in 1935, in response to the Great Depression, as insurance to protect older Americans and widowers. Medicare, a program established to provide health insurance for those 65 and older, Today the resource is funded primarily through payroll taxes.
Social security tax is paid at a rate of 12.4% of earnings (up to an annual cap) and if you are an employee you get the benefit of splitting the tax with your employer. The annual cap, also known as the Social Security wage base, was $137,700 in 2020, $142,800 in 2021 and will likely increase each year.
Medicare is taxed at 2.9% and shared equally among employee and employer. Medicare does not have an annual cap so you’ll pay it if you make $10,000 or $1,000,000. Together the two taxes are referred to as self-employment tax.
NOTE: If your income is high enough you could be subject to the additional Medicare tax which tacks on an additional 0.9% to what you owe.
Currently the additional Medicare tax applies to those earning:
$250,000 for married filing jointly
$200,000 for single, head of household and qualified widowers
$125,000 for married filing separate
If you are self employed you are solely responsible for the full amount of Social Security and Medicare.
How To Pay Taxes When Self Employed
It’s not just self employment taxes that a sole proprietor has to worry about, it’s income tax too. If you own your own business or are hired as an independent contractor you must file a federal income tax return if you earn more than $400 for the year.
How do you know if you’ll make more than $400? Bookkeeping! It’s important for anyone who is self employed to stay on top of their earnings. New sole proprietors make the mistake of focusing on their gross sales and not knowing their net earnings. After all it’s in the net earnings that the self-employment and income taxes are paid. (Net earnings are sales minus expenses).
Self-employed individuals don’t have the luxury of having taxes withheld from their paycheck for them. Instead they must submit their self employment and an estimate of the year’s income taxes to the IRS on a quarterly basis.
There are several options available to make the estimated and self employment taxes. One way is by mailing in payment with a Form 1040-ES payment voucher. Another method is through the electronic federal payment system (EFTPS).