By Are you considering joining the Great Resignation and becoming self-employed to be in charge of yourself?
Yes?
Okay, but before leaping, consider the tax implications. This self-employment thing may not be as rosy as it appears.
Here’s the big picture.
Don’t Believe the Hype
Despite what some may believe, becoming self-employed won’t allow you to
- write off all your meals as a business expense,
- deduct the cost of taking your friends to sporting events,
- deduct all your transportation expenses, and
- write off the entire cost of owning or renting a residence that contains your home office.
Sorry about that.
While there are some tax advantages to being self-employed, they are underwhelming and should not be the main reason for deciding to go out on your own.
The big non-tax disadvantage is you’ll have to pay for things that were formerly provided by your employer, such as
- health insurance,
- retirement plan contributions,
- a company car (if you were lucky),
- company-paid business trips that included elements of pleasure,
- meals when you worked late at the office, and
- so forth.
And there is one big tax disadvantage: the dreaded self-employment tax.
Now, some details on the tax issues most likely to affect you as a self-employed taxpayer.
The Dreaded Self-Employment Tax Can Be Really Expensive
The self-employment tax is how our beloved U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income (e.g., net income from Schedule C multiplied by 92.35 percent).
That 15.3 percent rate is composed of:
- 12.4 percent for the Social Security tax component of the self-employment tax plus
- 2.9 percent for the Medicare tax component.
Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9 percent Medicare tax continues before rising to 3.8 percent at higher self-employment income levels (above $200,000 if you’re unmarried or $250,000 if you’re a married joint-filer). The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.
Side note. The additional Medicare tax applies to an employee’s W-2 income in the same manner that it applies to self-employment income. It kicks in at the $200,000/$250,000 levels.
Once you’re in the 3.8 percent bracket, it continues to hit your net self-employment income up “to infinity and beyond,” as Buzz Lightyear would say.
Key point. When you were an employee, your employer paid half of the 12.4 percent Social Security tax and half of the 2.9 percent Medicare tax. You paid the other half. Your employer took what you paid from your salary. But now that you’re self-employed, you cover both halves out of your own pocket.
Bottom line: If you make good money, the self-employment tax can be a big number. You’ll need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.
If, after reading the above, you are ready for self-employment, call me on my direct line at 408-778-9651, and let’s talk about getting you set up with some tax deductions to offset your tax bite.