Welcome to the new "Tax & Money Stuff" column, a partnership with Hannah Cole. Hannah is a tax expert who specializes in working with creative businesses and artists. A long-time working artist, the financial challenges of freelancers and small creative businesses are both relevant and personal to her. She is the founder of Sunlight Tax. Read her post about saving for retirement here.
Guest post by Hannah Cole
Self Employment tax is two identical pieces, each 7.65%, totaling 15.3%
You’ve dreamed of quitting your job and striking out on your own. You’ve gathered some clients, or sold some artwork, and suddenly this year, you’re making some real money. But then you hit a speedbump. You file your taxes this year and discover that you owe money - a lot of money - that you didn’t expect to owe. Uh oh. This is a rude surprise that many freelancers encounter when starting out. The good news is, you’re making money. But the bad news is that anytime you make money, the government wants its share. And for a lot of freelancers, that share is a lot bigger than they realized.
Self Employment Tax, Explained
Our tax system is “pay as you go.” Everyone is supposed to pay taxes all year long, as they earn income. When you work as an employee, your employer takes care of the logistics for you - they withhold 7.65% from your paycheck for Social Security and Medicare (also known as FICA). In other words, you are paying the Federal government 7.65% of your paycheck towards Social Security and Medicare, but you don’t have to think about it. In addition, your employer pays, out of their own pocket, another 7.65% towards Social Security and Medicare, on your behalf. This is called “payroll tax.” If you’ve ever wondered why so many businesses try to pay people as contractors (reported on a 1099) and not as employees (reported on a W2) - this is the reason. It automatically costs them 7.65% extra to treat you as an employee. (And it is fair and contributes to a healthy society, if I may say so).
Now what happens when you work for yourself? First, there is no payroll department taking care of this stuff for you. You have to figure it out yourself. You must pay the government the same 7.65% of your income toward Social Security and Medicare that you would have as an employee. However, since you are also the employer now, you also have to pay the second half of the Social Security/Medicare equation.
Two sides of the FICA equation
Except now, instead of calling it “payroll tax” you call it “self-employment tax.” You pay a full 15.3% of your income (that’s 7.65 + 7.65) towards Social Security and Medicare, because you are both an employee and an employer. Those are the broad strokes of self-employment tax. If you’re not a details person, you can stop here, and just remember that about 15% of your freelance income must be set aside for Social Security and Medicare. If you’re up for another detail, then read the twist in the footnote.*
When you’re self-employed, you’re going to pay this 15.3% on your net income, regardless of how much income that is. But it’s important to note that your income tax is over and above this amount. Your income tax is a percentage of your taxable income (that is, your net income after taking certain deductions), based on your tax bracket. So keep in mind that setting aside 15.3% of your self-employment income isn’t enough. You’ll need to put aside enough to cover both your self-employment tax and your income tax. Now that I’ve explained what self-employment tax is, I’ll be covering strategies for putting enough money aside for your taxes in an upcoming post.
So back to you and your new freelance income. If you aren’t expecting it, the first year’s tax bill can be brutal. In my tax practice, I see a lot of freelancers after their first year making a decent income from self-employment, who are blindsided by how much tax they owe. And generally, the reason for their surprise is that while they were expecting the income tax part, they didn’t account for the self-employment tax. This is where estimated quarterly taxes come in. They take the sting out of the April tax bill, and become obligatory by law once you have a large enough tax obligation. Stay tuned for those details in the next post.
Hannah is a tax expert who specializes in working with creative businesses and their owners. A long-time working artist, the financial challenges of freelancers and small creative businesses are both relevant and personal to her. She is the founder of Sunlight Tax. Follow Hannah on Twitter at @sunlight_tax, or sign up for her newsletter to get friendly, timely updates about money stuff for creative people.
*Here’s the twist: When you are self-employed, one half of your Social Security/Medicare tax (7.65%) is tax-deductible. So you actually pay one of your halves on 92.35% of your income (100% - 7.65% = 92.35%), and the other half on 100%. A little tricky, but it’s a deduction that works in your favor.
Disclaimer: This is meant as a guide, not professional advice. If you have questions about your own situation, talk to a tax professional.