Self-Employment Tax

Self-Employment Tax is a levy imposed by the government, primarily in the United States, on individuals who work for themselves. Think of it as the solopreneur's version of the payroll taxes that traditional employees and their employers split. It is composed of two main parts: Social Security tax and Medicare tax. For regular employees, these are known as FICA taxes, with the employer paying half and the employee paying the other half. When you're self-employed, you wear both hats—employer and employee—so you are responsible for paying the full amount yourself. This tax ensures that freelancers, independent contractors, and small business owners contribute to these crucial social safety nets, allowing them to receive Social Security and Medicare benefits in retirement, just like their traditionally employed counterparts. Understanding this tax is fundamental for anyone earning income outside of a standard paycheck.

If you're a freelancer, run your own business as a sole proprietor, or work as an independent contractor, the Internal Revenue Service (IRS) in the U.S. generally considers you self-employed. The rule of thumb is that if your net earnings from self-employment are $400 or more in a year, you are required to file a tax return and pay self-employment tax. The logic is simple: in a typical job, your employer withholds Social Security and Medicare taxes from your paycheck and then matches that contribution. When you're your own boss, there's no employer to pay that other half. The self-employment tax is the mechanism that collects both the employee and employer portions from you directly. This ensures the system is funded equitably, and more importantly, it makes you eligible for future benefits based on your earnings history.

At first glance, the self-employment tax rate can look intimidating, but a couple of key deductions soften the blow.

The self-employment tax rate is 15.3% on your net earnings. This rate is broken down as follows:

• Social Security: 12.4% on earnings up to an annual limit. This limit, known as the Social Security wage base, changes almost every year. For example, in 2024, it's $168,600. Any self-employment income above this threshold is not subject to the Social Security portion of the tax.
• Medicare: 2.9% on all of your net earnings. Unlike Social Security, there is no income limit for the Medicare tax. The more you earn, the more you pay into Medicare.

Fortunately, you don't calculate the 15.3% tax on every dollar you make. The IRS allows for two very important adjustments:

1. First, you only pay self-employment tax on 92.35% of your net earnings from your business. This initial deduction is intended to put self-employed individuals on a more equal footing with traditionally employed workers, whose employers get to deduct their share of FICA taxes.
2. Second, you get to deduct one-half of your self-employment tax when calculating your Adjusted Gross Income (AGI). This is a fantastic above-the-line deduction, meaning you can take it even if you don't itemize. This deduction effectively recognizes the “employer” portion of your tax as a business expense, reducing your overall income tax liability.

For investors, the most crucial thing to understand about self-employment tax is what it doesn't apply to.

This is the key takeaway: Self-employment tax applies only to earned income from a trade or business you actively participate in. It does not apply to passive income. This means your profits from investments are safe from this particular tax. You will not pay self-employment tax on:

• Dividends received from stocks.
• Interest earned from bonds or savings accounts.
• Capital gains realized from selling securities, real estate, or other assets (provided you are not a professional trader or dealer).

While investment income isn't subject to self-employment tax, high-income investors should be aware of the Net Investment Income Tax (NIIT), a separate 3.8% tax that can apply to dividends, interest, and capital gains.

How you legally structure your business can have a major impact on your tax obligations. While a sole proprietorship is simple, all net profit is subject to self-employment tax. Many successful business owners choose to form an S Corporation. This allows them to pay themselves a “reasonable salary,” which is subject to FICA taxes (the employee/employer equivalent). Any remaining profit from the business can then be paid out as a distribution, which is not subject to self-employment tax. This can be a powerful strategy for reducing your tax burden as your business grows, allowing you to keep more of your hard-earned money to reinvest.