Self-Employment Tax: A Comprehensive Guide for Understanding Gross vs. Net Income

Self-employment tax is a crucial aspect of financial obligations for individuals engaged in self-employment or freelance work. It ensures that these individuals contribute to Social Security and Medicare, similar to traditional employees. Understanding the nuances of self-employment tax, particularly the distinction between gross and net income, is essential for accurate tax calculations and financial planning.

Gross vs. Net Income: A Fundamental Distinction

Gross income represents the total amount of income earned from self-employment activities before deducting any expenses. This includes revenue from sales, fees, or commissions.

Net income, on the other hand, is the amount of income remaining after subtracting allowable business expenses from gross income. These expenses can include costs associated with operating the business, such as rent, utilities, supplies, and equipment.

Self-Employment Tax Calculation: Net Income as the Basis

The self-employment tax is calculated based on net income, not gross income. This means that self-employed individuals are only subject to the tax on the income that remains after deducting eligible business expenses.

Determining Net Income: Deductible Expenses

The Internal Revenue Service (IRS) allows self-employed individuals to deduct ordinary and necessary business expenses from their gross income to arrive at net income. Some common deductible expenses include:

Rent or mortgage payments for business premises
Utilities (electricity, gas, water)
Office supplies and equipment
Travel expenses
Vehicle expenses
Health insurance premiums

Self-Employment Tax Rate: A Two-Tier Structure

The self-employment tax consists of two components:

Social Security tax: 12.4% of net income, up to a maximum threshold (adjusted annually)
Medicare tax: 2.9% of net income, with no maximum threshold

Additional Medicare Tax: Surcharge for High Earners

In addition to the standard Medicare tax, there is an additional 0.9% Medicare surtax for individuals with net income exceeding certain thresholds:

$200,000 for single filers and heads of household
$250,000 for married couples filing jointly
$125,000 for married couples filing separately

Filing Requirements: Form 1040 and Schedule SE

Self-employed individuals must file an annual tax return using Form 1040. Additionally, they must complete Schedule SE (Form 1040), Self-Employment Tax, to calculate and report their self-employment tax liability.

Estimated Tax Payments: Quarterly Obligations

Self-employed individuals are generally required to make estimated tax payments throughout the year to avoid penalties. These payments are based on the estimated amount of self-employment tax owed.

Understanding the distinction between gross and net income is critical for accurate self-employment tax calculations. By deducting eligible business expenses from gross income, self-employed individuals can reduce their taxable income and minimize their tax liability. It is important to consult with a tax professional or refer to IRS resources for guidance on specific deductions and tax obligations.

How The Self Employment Tax Works (And How You Can Avoid It!)

FAQ

Do you pay self-employment tax on adjusted gross income or gross income?

The 15.3% tax seems high, but the good news is that you only pay self-employment tax on net earnings. This means that you can first subtract any deductions, such as business expenses, from your gross earnings. One available deduction is half of the Social Security and Medicare taxes.

How do self-employed pay taxes?

As a self-employed individual, generally you are required to file an annual income tax return and pay estimated taxes quarterly. Self-employed individuals generally must pay self-employment (SE) tax as well as income tax. SE tax is a Social Security and Medicare tax primarily for individuals who work for themselves.

How much should I set aside for self-employed taxes?

With that in mind, it’s best practice to save about 25–30% of your self-employed income to pay for taxes. And, remember, the more deductions you find, the less you’ll have to pay.

Why is 30% tax for self-employed?

That “30% rule of thumb” comes from the fact that self-employment income is taxed at an additional 15.3% to make sure that self-employed people still pay Medicare and Social Security tax.

How much is self-employment tax?

Generally, 92.35% of your net earnings from self-employment is subject to self-employment tax. Once you’ve determined how much of your net earnings from self-employment are subject to tax, apply the 15.3% tax rate. Remember, though — for 2023, only the first $160,200 of earnings is subject to the Social Security portion of self-employment tax.

Do I have to pay self-employment tax?

You usually must pay self-employment tax if you had net earnings from self-employment of $400 or more. Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment.

Is self-employment tax the same as income tax?

Self-employment tax is not the same as income tax. For the 2023 tax year, the first $160,200 of earnings is subject to the Social Security portion. This is up from $147,000 in 2022. A 0.9% additional Medicare tax may also apply if your net earnings from self-employment exceed $200,000 if you’re a single filer or $250,000 if you’re filing jointly.

Are self-employment earnings tax deductible?

For tax purposes, net earnings usually are your gross income from self-employment minus your business expenses. Generally, 92.35% of your net earnings from self-employment is subject to self-employment tax. Once you’ve determined how much of your net earnings from self-employment are subject to tax, apply the 15.3% tax rate.