How Self Employment Tax Works


Self-Employment Tax is basically a Social Security and Medicare Tax also called as SE Tax for individuals who work for themselves. Examples of self employment are running a home business, farming, driving a cab etc. The self employment tax returns are filed using Schedule SE (Form 1040). Also one can deduct half of SE tax in figuring adjusted gross income. Wage earners cannot deduct social security and Medicare taxes. The self employment tax rate is 12.4% for Social Security and 2.9% for Medicare.

The tax is levied only on the first $94,200 of your combined wages, tips, and net earnings in 2006 and is subject to any combination of the 12.4% social security part of SE tax, social security tax, or railroad retirement (tier 1) tax. The earnings above $94,200 is only subject to Medicare tax which is 2.9%

You can reduce self-employment income by 7.65% before applying the tax rate. For instance, if your net self-employment income is $40,000. That's the amount that is reported as taxable for income tax purposes on Form 1040. But when actually calculating your self-employment tax on Schedule SE, Computation of Social Security Self-Employment Tax, the taxable amount is $36,940. Not paying the 15.3% tax on $3,060 difference in this example saves you $468.

Also, another good thing about self employment tax is that you can claim 50% your self-employment tax as deduction. A $2,000 self-employment tax payment reduces taxable income by $1,000.

Example:

You run a home business as a sole proprietor. In 2006 your net profit as reported on Schedule C is $40,000.Your net earnings as calculated on Form SE would be $36,940 ($40,000 x 0.9235). Your self-employment tax would be $5,651 (36,940 x 0.153) and you would report that on Form 1040 in the Other Taxes section. Then you would report one half of your self-employment tax, $2,825, ($5,651 X .50) on the 1040 as an adjustment to income, which will reduce your adjusted gross income and consequently the amount of income tax you owe.

You must pay your income tax if the income from your self employment is more than $400 excluding church employee income and the second condition is if you earn more than $108.28 of church income. The net income from self employment is subjected to SE Tax.

If you earn both wages and self employment income, then first the tax on your wages is paid. But this rule applies only if your total earnings are more than $94,200.

For example:

If you earned $25,000 in wages and $25,000 in self-employment income in 2005, you pay the appropriate Social Security taxes on both your wages and business earnings. However, in 2006, if your wages are $75,000 and you have $20,000 in net earnings from a business, you do not pay dual Social Security taxes on earnings more than $94,200. The employer will withhold 7.65 percent in Social Security and Medicare taxes on your $75,000 in earnings. You must pay 15.3 percent in Social Security and Medicare taxes on your first $19,200 in self-employment earnings and 2.9 percent in Medicare tax on the remaining $800 in earnings.

As the Self Employment Tax is based on Net Income, It is very important to calculate the net earnings properly and report all earnings up to the maximum, as per the law.



Calculating your net earnings

Net earnings are your gross earnings from your trade or business, minus your allowable business expenses and depreciation.
Some types of income do not count for self employment thus and should not be included in figuring your net earnings and they are:

• Dividends from stocks and interest from bonds, unless you receive them as a dealer in stocks and securities
• Interest from loans, unless you lend money
• Rentals from real estate, unless you are a real estate dealer or broker.
• Income received from a limited partnership.