If you're self-employed as a sole proprietor, partner, or LLC member, you may owe the self-employment tax.
The tax is the government's way of collecting Social Security and Medicare taxes from your net self employment income. Any tax owed is in addition to any income taxes owed to the Feds and your state.
Here's what you need to know about the self-employment tax.
First Stop: Social Security and Medicare Tax
If you're an employee, a portion of your wages is hit with a Social Security tax. The amount is called the wage base and it is linked to the increase in average wages, not the Consumer Price Index. In 2015, the Social Security tax is 12.4 percent on the first $118,500 in wages (up from $117,000 in 2014).
All of your wages are hit with the Medicare tax of 2.9 percent. That tax climbs to 3.8 percent at higher income levels: $200,000 for unmarried folks and $250,000 for married joint-filing couples.
In general, half of these federal employment taxes are withheld from your paychecks while the other half gets paid by your employer. However, you pay the extra 0.9 percent Medicare tax if you are a high earner. Your employer doesn't owe any part of this.
Second Stop: Self-Employment Tax
Self-employed folks must bear the full brunt of these two taxes combined, either in quarterly estimated tax payments or when they file their federal income tax returns. For 2015, the maximum 15.3 percent self-employment tax rate is on your first $118,500 of self-employment income (up from $117,000 for 2014). If your income exceeds the $118,500 ceiling, additional net income will be subject to the 2.9 percent Medicare tax. The additional 0.9 percent Medicare tax applies once your net self-employment income exceeds the applicable threshold ($200,000 for unmarried individuals or $250,000 for married joint filing couples).
The Future of the Self-Employment Tax
What you pay in self-employment taxes is likely to increase. As the Social Security tax ceiling increases to account for inflation, more and more of your income will be socked with the 12.4 percent Social Security tax.
According to the Social Security Administration's latest projection, the Social Security tax ceiling is expected to increase to $165,600 for 2022. That would mean a Social Security and Medicare tax bill of $25,337 on self-employment net income of $165,600.
Some observers think there is a good change the tax ceiling will increase beyond the projected number or even be removed in an attempt to put the Social Security system on a sounder financial footing. Without a ceiling, you would owe the full 12.4 percent Social Security tax on every dollar you earn.
Now for the Good News
It is not all doom and gloom, however. The good bits of news include:
If you have a job and have Social Security tax taken out of your wages, you get credit when calculating your self-employment tax bill. For example, say your 2015 salary is $100,000 and you also earned $50,000 of net self-employment income from a side business last year. You only have to pay the maximum 15.3 percent self employment tax rate on the first $18,500 of your net self-employment income because you get credit for already having paid Social Security tax on your $100,000 salary. However, you must still pay the 2.9 percent Medicare tax on your self-employment income. This gets taken care of automatically when your tax accountant fills out Schedule SE while preparing your Form 1040.
You can generally deduct 50 percent of your self-employment tax bill on page 1 of Form 1040. The write-off is available whether you itemize or not. However you cannot deduct any portion of the extra 0.9 percent Medicare tax on high earners.
You generally don't have to pay self-employment tax on profits from selling business assets that are not considered inventory. For example, say you sell a small office building that has been used for years to house your unincorporated business. You don't owe any self-employment tax on the gain.
Your tax adviser also may be able to suggest some ways to lower your self-employment tax bill.