6 things to know about self-employment tax

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6 Things to Know About Self-Employment Tax

A 2019 FreshBooks research report called “Self-Employment in America” revealed that the number of self-employed Americans is rising rapidly.  Roughly 24 million people in the U.S. now employ themselves, including freelancers, gig workers, independent contractors, small business owners and startup founders. Many of these people prefer the freedom and control they have over their work.

 

What they may not enjoy are self-employment taxes that workers in traditional jobs don’t have to pay. Weighed against all the benefits of being self-employed, this tax is actually a minor inconvenience that you can minimize with the right strategy.

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Keep reading to learn more about self-employment tax and how to address it as part of your financial strategy.

1. Know the definition of self-employment tax

Self-employment tax includes Social Security and Medicare taxes. Since self-employed individuals don’t receive traditional paychecks where taxes are deducted from each check, the self-employment tax replaces the traditional Social Security and Medicare withholding.

 

In 1935, the Federal Government established the Federal Insurance Contribution Act (FICA) to help fund Social Security and Medicare. Right now, the FICA tax is 15.3%. This amount is split between employers and traditional employees, with each paying 7.65%.

 

As self-employment developed, the federal government wanted to make sure these people paid their fair share into Social Security and Medicare coffers. In 1954, the federal government established the Self-Employed Contributions Act (SECA) that required self-employed individuals pay the entire 15.3%. Sometimes, the self-employment tax is referred to as the SECA tax.

2. Understand how to calculate self-employment tax

Use Schedule SE that accompanies Form 1040 or 1040-SR for tax filings. This schedule serves as a worksheet to calculate your self-employment tax. The tax rate is 15.3%, which consists of 12.4% for Social Security and 2.9% for Medicare. The amount is calculated on net earnings, which means you first subtract any deductions like business expenses from the gross earnings amount.

 

Each year, the IRS may change the portion of total wages, tips and net earnings that are subject to self-employment tax.  In 2019, the first $132,900 was subject to the Social Security portion of the self-employment tax rate. For 2020, this amount was raised to $137,700. All of your combined wages, tips and net earnings above this amount are subject to the 2.9% Medicare part of the self-employment tax.

 

That’s not the end of it, however. Since 2013, as part of the Affordable Care Act (ACA), there is also a 0.9% Medicare surtax on any income over a certain threshold amount. The threshold is $200,000 for individuals filing as single, $250,000 for married couples filing jointly and $125,000 for married couples filing separately. Anything over those amounts is taxed at that 0.9% rate.

3. Determine if you actually need to pay self-employment tax

Self-employed individuals who have a trade or business and operate as a sole proprietor or an independent contractor must pay self-employment tax. This tax is paid in addition to income tax paid by small business owners, freelancers, gig workers and more.

 

To determine if you must pay a self-employment tax based on your earnings, you must calculate the net profit or net loss from your business. If your net earnings are more than $400, then you have to file an income tax return and calculate your self-employment tax.

 

The self-employment tax obligation basically applies to anyone who works and doesn’t have taxes automatically taken out of their checks by an employer. It applies to all age demographics and income brackets. Even those who already collect Social Security benefits can be subject to self-employment tax if they work for themselves.

4. Remember that self-employment tax is also a deductible expense

It’s possible to deduct a portion of your self-employment tax to offset some of your income tax. However, that does not affect self-employment net earnings or self-employment tax. Additionally, if you file a Schedule C with your Form 1040 or 1040-SR, you may be eligible for the Earned Income Tax Credit (EITC).

 

Another small financial relief is the self-employment health insurance tax deduction. A percentage of the cost of health insurance for your self-employed healthcare plan may be deducted if you pay it directly. If you pay it through an insurance marketplace like CoveredCA, you cannot claim this deduction because you are already receiving a credit on the cost of the insurance plan.

5. Know how to pay your self-employment tax

Your self-employment tax amount is recorded on your tax filing and becomes part of the overall calculations that will determine if you will owe money or if you will receive a refund. In order to file your taxes, which includes payment for self-employment tax, you must have a Social Security Number (SSN) or an Individual Taxpayer Identification Number (ITIN).

 

As a self-employed individual, you are also required to make quarterly estimated tax payments, which includes payment for estimated income tax and estimated self-employment tax for the year.

6. Reach out to a tax professional for advice about self-employment tax

Self-employed individuals can quickly face complex tax filings, which may lead them to miss out on deductions or benefits or even to file incorrectly and risk incurring fines. Typically, employers perform many of the tax calculations for a traditional employee. However, as a freelancer, gig worker, or other type of self-employed individual, you’ll need to perform these calculations yourself.

 

If this makes you nervous because you are not a number-cruncher or you are new to self-employment taxes, then it’s a good idea to seek the assistance of a tax professional. They are trained to do the calculations for you, file your taxes and guide you on how to make your estimated tax payments.

 

Moreover, an accountant or other tax professional can help you with planning on how to reduce your future taxable income through specific qualifying business deductions and retirement plan contributions.

 

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8 retirement plan options for the self-employed

 

You can avoid costly retirement mistakes by picking the right retirement plan for yourself and your business.

As a self-employed freelance writer, I spent hours researching and learning about different self-employed retirement plans. When you’re self-employed or run a small business, these retirement savings plans are not an automatic benefit like an employer-sponsored 401(k) or pension plan that many employees receive as part of their job.

Thankfully, there are a number of self-employed retirement plan options, but each comes with its own benefits and limitations. Ultimately, I settled on a solo 401(k) for my business, but that doesn’t mean it’s the best fit for everyone.

Here’s everything you need to know about self-employed retirement plans and how to choose the right plan for you. We’ll talk through the plans one by one, and then give you some tips on how to open the retirement account of your choosing, so you can start putting aside some of your self-employment income to create a successful retirement scenario for yourself.

Related: 7 brilliant moves to thrive in an uncertain economy

 

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An individual retirement account — IRA for short — is a type of retirement plan that anyone can use, including self-employed individuals. You can contribute to an IRA in addition to other self-employed retirement plans, and depending on your income and the type of account you choose, you may be able to take advantage of tax savings.

With a traditional IRA, you may be able to deduct your contributions when you file your tax return every year. Any earnings you receive will be taxed on a tax-deferred basis when you withdraw them in retirement. That means you’ll pay taxes on them according to your tax rate at the time of withdrawal.

In contrast, a Roth IRA doesn’t allow you to deduct contributions from your taxable income. You pay taxes on those contributions in the year you make them, and then when you take the money out in retirement, you receive it tax-free.

However, there are some limitations that can reduce the value of an IRA, depending on your situation:

  • In 2020, IRA contribution limits are set at a maximum of $6,000 or your taxable compensation for the year, whichever is less. If you’re age 50 or older, that limit goes up to $7,000.
  • Contributions made in excess of the annual limit will be taxed at 6% for each year they remain in the IRA.
  • Depending on your modified adjusted gross income on your tax return, you may not be able to contribute to a Roth IRA, or you may be subject to a lower contribution limit.
  • Your MAGI may also impact your ability to deduct contributions you make to a traditional IRA. IRA deduction limits can vary based on whether you also have an employer-sponsored retirement plan.
  • If you take withdrawals from an IRA before you reach age 59 1/2, you may have to pay taxes on the amount plus a 10% penalty for early withdrawals. There are, however, exceptions to this rule.

Because of the nature of IRAs, they can be a great way to supplement savings you’ve put into a self-employed retirement plan. However, because of their low annual contribution limit, they’re not the best option as a primary retirement plan.

 

 

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Also called a one-participant 401(k), a solo-k, a uni-k, or a one-participant k, a solo 401(k) is designed specifically for small business owners who have no employees (other than a spouse, if applicable).

In general, a solo 401(k) functions similarly to an employer-sponsored 401(k). You’ll make contributions with pre-tax dollars, and these contributions will grow tax-deferred until you take withdrawals in retirement.

There are, however, a few differences besides the single-participant nature. For starters, as the business owner, you can make contributions as yourself and also as the employer:

  • In 2020, you can make employee contributions of up to $19,500 as an individual; if you’re age 50 or older, you can add another $6,000 in catch-up contributions.
  • As the business owner, you can make employer contributions of up to 25% of your compensation annually, up to a maximum of $57,000 in 2020.

Those employer contributions can also be counted as a business expense, further reducing your tax liability each year. Depending on which plan provider you go through, solo 401(k)s are relatively inexpensive. For instance, I paid a few hundred dollars to set up mine plus an ongoing monthly fee of $25.

Unlike with an IRA, you may be able to set up a loan option with your solo 401(k), though interest charges will be involved. In addition, doing something like taking a 401(k) loan to pay off debt and borrowing from your own retirement should be considered only as a last resort.

All that said, here are some potential drawbacks of a solo 401(k) to consider:

  • As with IRAs, if you take withdrawals from a solo 401(k) account before you reach age 59 1/2, you’ll be assessed taxes plus a 10% penalty. Although there may be options to allow loans or hardship withdrawals, there are fewer exceptions to the 10% early withdrawal penalty than you’d get with an IRA.
  • You’re not eligible to open this plan if you employ anyone besides yourself and your spouse, though 1099 workers don’t count.
  • You may not be eligible if you’re also covered under an employer-sponsored retirement plan — for example, you work as an employee at a company and also run a side business in your spare time.

Because of how a solo 401(k) is set up, you might consider it if you’re an independent contractor or sole proprietor with no salaried employees — though, you can still qualify even if you employ your spouse.

 

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Simplified Employee Pension IRA is a type of IRA that you can establish to benefit you, your employees, or both. The primary difference between a SEP IRA and a traditional or Roth IRA is that only an employer can contribute to a SEP IRA.

The maximum contribution amount for each employee, including yourself, is the lesser of 25% of compensation or $57,000 in 2020. A SEP IRA functions similarly to a traditional IRA for tax purposes, which means your earnings will grow tax-deferred. Also, your contributions as the employer are tax-deductible.

If you want to make separate contributions to a traditional or Roth IRA, you can. In some cases, however, you may be permitted to make your personal IRA contributions to your SEP IRA.

Here are some potential issues you might run into with a SEP IRA:

  • A SEP IRA allows only employer contributions, unlike a solo 401(k), which allows you to contribute to your self-employed retirement plan as an individual and an employer.
  • If you have employees, you must contribute the same percentage of salary for each person who’s participating in the plan. That includes employees who are no longer employed on the last day of the year.
  • If you take a withdrawal before age 59 1/2, you’ll need to pay income tax and a 10% penalty on the distribution. There are, however, some exceptions to the 10% penalty requirement, which are the same as traditional and Roth IRA exceptions.
  • You can’t borrow from a SEP IRA as you can a solo 401(k).

A SEP IRA is for business owners who want the simplicity and lost cost of an IRA, but with a much higher contribution maximum. There’s also less paperwork involved than with a solo 401(k).

 

Andrii Dodonov / istockphoto

 

A Savings Incentive Match Plan for Employees IRA allows both employers and employees to contribute to a traditional IRA. In 2020, you can contribute $13,500 as an individual or $16,500 if you’re age 50 or older. The same limit applies to any employees. As the employer, you can also choose to make a nonelective contribution of 2% of compensation or a matching contribution of up to 3% of compensation.

Because the SIMPLE IRA is designed as a traditional IRA, your contributions are tax deductible in the year you make them, and your earnings will grow tax-deferred. You can also contribute to a traditional or Roth IRA on your own.

Here are some important things to know about the SIMPLE IRA:

  • Although the structure of a SIMPLE IRA is similar to a solo 401(k), in that you can contribute as the employer and individual, its contribution limits are lower.
  • You can’t borrow from a SIMPLE IRA as you can a solo 401(k).
  • You may need to work with a special custodian to open a SIMPLE IRA account.
  • Withdrawals made before age 59 1/2 will be subject to income tax and a 10% penalty, though there are the same exceptions to the penalty as other IRA plans.

Consider a SIMPLE IRA if you want the chance to contribute as the business owner and an individual, but don’t expect to need the higher plan contribution limits of a solo 401(k). This self-employed retirement plan is also better if you have employees and don’t qualify for a solo 401(k).

 

designer491 / istockphoto

 

A Health Savings Account isn’t technically a retirement plan, but you can use one to set money aside to use in retirement. You can use this account in addition to one of the other self-employed retirement plans and a traditional or Roth IRA. In fact, I contribute to both a solo 401(k) and an HSA every year.

HSAs are available to taxpayers, including business owners, who have a high-deductible health plan. You can set aside money in the account to use for out-of-pocket medical expenses on a tax-free basis. In other words, your HSA contributions are tax-deductible, and you won’t pay any taxes when you make withdrawals for eligible medical expenses. If you take withdrawals for ineligible reasons, the amount will be subject to income taxes plus a 20% penalty.

That said, if you hold onto your HSA funds until you’re 65 or older, withdrawals for non-medical reasons will still be subject to income tax but not the additional 20% penalty. As a result, an HSA can function similarly to a tax-deferred retirement account. Of course, you can also use HSA funds to pay for health care costs in retirement and avoid all tax-related costs.

In 2020, you can contribute up to $3,550 to an HSA if you’re the only one on your health insurance plan, or up to $7,100 if you have a family plan. Depending on your HSA provider, you may be able to invest these funds.

If you’re considering an HSA, here are some things to keep in mind:

  • Because it’s not a traditional retirement plan, it’s not a good idea to rely solely on an HSA to save for your future.
  • You won’t qualify for an HSA if you don’t have a high-deductible health plan.
  • HSA contribution limits are lower than most other self-employed retirement plans.

If you qualify, consider an HSA as a way to supplement your other retirement contributions. Keep in mind, though, that any ongoing medical expenses may make it challenging to use the funds to save for retirement.

 

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Depending on your personal financial situation, you may also consider other types of small business retirement plans. Here are a few less-common options that self-employed people might consider.

Take some time to consider all of your options to determine which retirement plan is right for you. Also, consider consulting with a tax professional and/or financial advisor to get an idea of which plans would benefit you most when it comes to your tax planning.

 

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A tax-deferred pension account, a Keogh plan allows you to set up a defined-benefit or defined-contribution plan. Keogh plans are relatively complicated and require more upkeep and costs than other types of self-employed retirement plans.

 

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With a Keogh plan or a separate defined-benefit plan, you’ll make contributions based on a set amount you aim to receive annually in retirement. There may be contribution limits, though, depending on how you plan to structure the plan.

 

designer491 / istockphoto

 

With this type of retirement plan, employees get a share in the profits of the business. There are no contributions from the employee with this type of plan, and contributions by the business will depend on quarterly or annual earnings.

 

Andrii Dodonov / istockphoto

 

In most cases, you can get any of these self-employed retirement plans from a major brokerage firm. In some cases, some brokers may not offer certain types of plans, so decide which plan you want to go with before you start shopping around.

As you compare brokers and their self-employed retirement plans, review several features, including:

  • Cost (setup and ongoing fees)
  • Ease of use and access
  • Administrative help
  • Investment options (mutual fundsETFs, etc.)
  • Resources and advice

There’s no single best investment broker for everyone, so it’s important to take your time and consider how to choose a brokerage that’s best for you and your business.

 

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Self-employment comes with a lot of perks. But without an employer-sponsored retirement plan, you’re responsible for making sure you have everything in place to save for your future. Saving for retirement sooner rather than later is important because it gives you more options when you’re ready to slow down or stop working entirely.

Think about your financial goals, ability to save and tax situation to help you determine which retirement plan is the best option for you. Also, think about the costs, upkeep, and potential pitfalls associated with each plan. The retirement planning process can take some time, but getting the right account set up could make it easier to avoid costly retirement mistakes in the long run.

Learn more:

This article originally appeared on FinanceBuzz.com and was syndicated by MediaFeed.org.

 

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