The Basics of Self-Employment Taxes

Interested in self-employment? There’s good news and there’s bad news. The good news: total freedom. Self-employment will bring a lifetime of working in your pajamas and taking “siestas” whenever you want. 

The bad news: freedom isn’t free.

We’re all aware of income taxes, of course, but the tax form labeled self employment taxes might catch you off guard the minute you’ve pivoted to become your own boss. 

Fortunately, if you know what to expect and how to handle them, self-employment taxes don’t have to be any more than a minor blip on your journey to financial independence.

The Self Employment Tax: What Is It?

Let’s start with the nitty-gritty definitions. What is self employment tax? Here are the basics, according to the IRS:

• Who is self-employed? You are, if you run a sole proprietorship, work as an independent contractor, or are otherwise responsible for your own income.
  
• What taxes do you have to pay? Income taxes and self-employment taxes, generally requiring paying quarterly taxes and filing a yearly tax return. Estimated tax payments can sound a bit intimidating, but they’ll credit toward your yearly tax liability.
  
• Why do I have to pay for the right to employ myself? Because when you receive flat fees for contracts as part of your business, you’re not paying the payroll taxes that go toward social security and other government services. The self-employment tax is essentially a substitute for what would otherwise come out of your paycheck.

What Are the Current Tax Rates?

The self employed tax rates stand at 15.3%—that’s a combination of 12.4% for social security and 2.9% for Medicare. There isn’t a special “self employment income tax rate” or unique bracket for being self employed. The income you earn will still apply to the basic federal income tax brackets.

Federal Income Taxes

As for your taxable income, there are several brackets in 2021, including:

• 10% for up to $9,950 for single filers
• 22% on money earned between $40,526 to $86,375 (single filers)
• 32% on money earned between $164,926 and $209,425 (again, single filers)

Taxes on self-employment income work the same as any other income: You’ll owe the income tax. And keep in mind that the bullets above are just a selection. There are more brackets that differ depending on whether you file as head of household or not. This is why a federal income tax calculator or even a 1099 tax calculator can get so confusing. 

Keep in mind that tax brackets don’t change your total federal income tax simply because you earn more money. In other words, if you earn over $523,000 per year as a single filer, you won’t pay 37% tax on all of those dollars. You’ll only pay the 37% tax rate on any dollar at $523,601 or more. The money you earn between $209,426 to $523,600 is still taxed at 35%. 

Splitting hairs, maybe, but it’s a point that many people forget. If this weren’t the case, some people might stop working for the year once they hit $523,600.

State Income Taxes

Fifty states, fifty different policies. 

State income taxes are generally lower than federal tax rates, but between the states, the taxes on self-employment income can vary wildly. States like California and Minnesota currently charge the highest rates on the top brackets—California charges over 13% and Minnesota nearly 10%. 

States That Have No Income Tax

As of 2021, the following states won’t charge you income tax while you live there:

• Alaska
• Florida
• Nevada
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

An additional 10 states have a flat state income tax, while the remaining states all have brackets in a style similar to federal income taxes.

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Estimated Taxes

One of the most jarring things about working for yourself is the sudden onset of estimated taxes. No longer do taxes come out for you with one simple tax return every year—usually, where a tax refund may be waiting for you if you’ve withheld too much.

Instead, you’ll be writing checks to the United States Treasury every quarter. Estimated taxes apply to your entire tax liability: self-employment taxes, income taxes, and other taxes that might apply. 

The “What, When, and Why” of Estimated Taxes

• What are estimated taxes? They’re quarterly tax payments you’ll send directly to your state and to the U.S. treasury.
  
• When do you pay estimated taxes? Every quarter. That typically means January 15, April 15, June 15, and September 15, although some cases (like holidays, or the pandemic of 2020) can change these dates.
  
• Why do you pay estimated taxes? Like the self employment tax, you were always regularly paying taxes to the government out of your paycheck via withholding. But you barely noticed it. Once you go self-employed, the government is no longer withholding money out of your paycheck. It’s up to you to make up the difference.

The first time you do it, the skills you need to estimate tax liabilities in the future won’t be intuitive. You have to factor in deductions, income tax, self-employment tax deductions, and more.

Federal Estimated Taxes

You’ll separate your tax liabilities by two entities: your federal tax liability and what you owe to your specific state. When you write checks to the federal government, you’ll write it directly to the United States Treasury. (Warning: may cause feelings of national pride.)

State Estimated Taxes

Remember that estimated taxes apply to all taxes you owe, not only income taxes. So even in zero income tax states like Florida or Washington, there may still be tax liabilities for you to consider.

How Much Will You Pay in Estimated Taxes? (and How to Track It)

That’s the million-dollar question. Is there some app you can use to pay taxes online or calculate federal income tax before you even know how much income you have?

The answer: not exactly. But there are a few things you can do to simplify the process. 

One is tracking all of your tax liabilities. Tax/accounting software like Wave and QuickBooks can help you track all of your business activity, especially if you have a proper business bank account set up. From there, you can generate a rough estimate of your tax liabilities to see how much you’ll owe when you project each quarter out to the full year.

Estimated Tax Calculators

To help out, the IRS provides an estimated tax calculator so you can get your bearings.

Pay Estimated Taxes Online

Good news: it’s 2021, so there’s no reason you have to rely on snail mail if you don’t want to. You can pay estimated taxes online at the IRS website. This gives you multiple options, including putting your taxes on a credit card.

What Happens If You Don’t Pay Them?

Two problems. First, you’ll owe more at the end of the tax year anyway. Second, you’ll likely owe more because you have to pay penalties. If you go on not paying your taxes, your problems only get worse and worse. It’s best to just pay them every quarter.

This may seem like a punishment for not being able to predict future income. However, you can potentially avoid penalties by paying at least as much as you did in estimated taxes the previous year.

Self-Employment Tax Deductions

Let’s say you earned $100,000 in a year, but spent $50,000 on valid self employed expenses running the business.

Did you really earn $100,000? Of course not. And the U.S. government understands that. 

Enter the world of business deductions. As you go through your tax return and adequately track your legitimate business expenses, you’ll likely see the overall total of your tax liability dwindle. 

This is because you’re moving from your gross receipts to the net. Gross income refers to everything you collected; taxable income is everything you earned that’s subject to tax. And the numbers can be completely different.

Handling Business Expenses

The key to business expenses: You need to keep records of everything you spend on your business. That way, you can verify every expense you list on your tax return that knocks a little bit from your tax liabilities.

What expenses qualify as legitimate business expenses that could reduce your tax liability? Costs of goods sold, business start-up costs, employees’ pay, business insurance, retirement plans—the IRS lists a lot of them on its website.

To keep things simple, you can use services like Expensify or other accounting software like Wave to keep tabs on your business expenses and store receipts.

Tips for Handling Self-Employment Taxes

Tip #1: Keep Business and Personal Money Separate

One of the cardinal rules of self-employment is not to mix business and personal money. It’s much harder to claim something was a business expense if you use your personal card to pay for it. Keep separate checking accounts and separate charge cards—for the sake of your own sanity.

Tip #2: Set Estimated Tax Money Aside as Soon as You Get Paid

If you don’t, estimated taxes have a way of sneaking up on you. Use your best judgment in determining a quarterly amount, then store that separately in a savings account until you’re ready to cut the check.

Tip #3: Set Calendar Reminders to Avoid Missing Deadlines

Look through a basic 2021 estimated tax calendar and set reminders. It’s only four dates a year, after all, and it will help you stay organized.

Tip #4: Set Up an IRS Account to See Payments

The IRS lets you set up an account with them directly so you can watch when your money goes through.

Tip #5: Consult an Accountant

Hopefully, you’ve gotten help from this article, but remember: everyone’s situation is different. To get specific answers to your tax questions, only an accountant will have the answers.

Making Self-Employment Work

The first time you hear about estimated and self-employment taxes, it’s going to sound intimidating. What if you get a decimal point wrong? Will the police knock down your door and shut you down? And how do you know if a self employment tax calculator is really going to be accurate?

It’s not that dramatic. As long as you know your responsibilities and keep track of the money moving in and out of your business, you can always ask an accountant what you need to do next. And once you have it down to a system, cutting an estimated tax check can be as simple as hitting a few buttons.

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