An independent contractor, however, is both the employer and the employee. To pay the full amount, a self-employed person is responsible for both halves, or 15.3% of earned income. This is known as the self-employment tax.
How to Calculate Self-Employment Tax
The 15.3% self-employment tax is composed of a 12.4% Social Security tax on the first $137,700 of net self-employment income for the year 2020 ($142,800 in 2021) and a Medicare tax of 2.9% on all net self-employment income.
Your self-employed income is any income from self-employed business activities (Schedule C), farming (Schedule F), the self-employed earnings of a partner (Schedule E), and work as clergy or employee of a religious organization.
The $137,700 ceiling is called the "Social Security wage base." It represents the maximum amount of income from wages and net self-employment income that's subject to the Social Security tax. This base increases a little each year to adjust for inflation.
Net self-employment income is your income after deducting business expenses, such as marketing expenses, store rent, or purchased inventory.
You would next adjust your net self-employment by multiplying it by 92.35%, which allows you to subtract out 7.65% as a business expense. The adjusted 92.35% takes into account the part of the Social Security and Medicare taxes as a deductible business expense for employers.
Self-employed taxpayers are permitted to deduct the employer’s portion of Social Security and Medicare taxes on their own tax returns.
This reduction in the base amount of income that's subject to the self-employment tax along with the above-the-line deduction available to self-employed taxpayers for the employer portion of the tax helps equalize the tax treatment between self-employed workers and wage employees.
Self-employment tax is calculated using Schedule SE form 1040 or 1040-SR. You must pay the self-employment tax even if you are already receiving Medicare or Social Security.
How to Reduce Self-Employment Tax
It is difficult to avoid paying the self-employment tax entirely. However, there are three good ways that you can reduce the amount of self-employment tax that you owe.
1. Increase Your Business Expenses
The only guaranteed way to lower your self-employment tax is to increase your business-related expenses. This will reduce your net income and correspondingly reduce your self-employment tax. Regular deductions such as the standard deduction or itemized deductions won't reduce your self-employment tax.
Above-the-line deductions for health insurance, SEP-IRA contributions, or solo 401(k) contributions will not reduce your self-employment tax, either. These deductions only reduce the federal income tax.
You may be able to lower your net income by taking the Section 179 deduction, which allows you to deduct the cost of certain fixed assets that are used for business. This will impact both your income tax and the self-employment tax, so you will need to speak with a tax professional to find out if you qualify.
2. Increase Tax During Years With Losses
Sometimes you may need to increase your self-employment tax in order to maintain eligibility for Social Security retirement or disability benefits.
In general, you need at least 40 Social Security credits over your lifetime to be eligible for retirement benefits and at least five years of credits out of 10 to be eligible for disability benefits.
Self-employed people who are facing a year in which they have lost money—their expenses were greater than their incomes—or a year in which their incomes are significantly lower than usual can use a special method, known as the "optional method," to increase their self-employment tax.
Self-employed persons who are not farmers or fishermen are limited to using the optional method only five times during their lifetimes. Rules for this method are found in the Instructions for Schedule SE.
3. Consider Forming an S-Corporation
The self-employment tax applies specifically to earned income. If your clients or customers pay your S-corp, rather than paying you directly, that's not yet considered income you have earned.
Once you form your S-corporation, you would pay yourself a percentage of your corporation's earnings as a salary and the remaining balance as dividends. The "salary" portion is earned income and is subject to self-employment tax. But dividends aren't subject to self-employment tax, so you've reduced your net self-employment income by whatever percentage you took as dividends.
Whether you choose to form an S-corp or use another strategy, effectively lowering your self-employment tax can be tricky. The best way to do it may change from year to year, especially as self-employment tax rates and income subject to these rates can change annually. To make sure you file your taxes correctly, enlist the help of a tax professional who specializes in self-employment.