Self-employment taxes replace payroll taxes for independent workers.
If you've worked for another person or company your whole life, most, if not all, of your tax burden was withdrawn from your paycheck in the form of payroll taxes. Once you become self-employed, you no longer receive traditional paychecks, although you're still liable for any income you earn. Self-employment taxes serve as a substitute for payroll taxes for the self-employed, and are due throughout the year to avoid penalties.
Self-Employment Tax
Because the Internal Revenue Service usually assesses taxes used to support Social Security and Medicare through payroll taxes, it uses the self-employment tax to ensure that independent workers pay their share for the programs, and all workers with more than $400 must pay the tax on those earnings. The IRS assesses a combined 15.3 percent tax rate on all self-employed earnings of up to $106,800 as for the 2010 tax year. Amounts in excess of $106,800 are taxed at a 2.9 percent rate. In the 2011 tax year, the 2010 Tax Relief Act reduces the self-employment tax rate to 13.3 percent on all self-employment earnings made during the 2011 calendar year.
Basis And Figuring Self-Employment Tax
Before a taxpayer calculates his self-employment tax, the IRS allows him to reduce his gross earnings -- the basis of his income tax rate -- by 7.65 percent. For example, a self-employed worker who earns $140,000 over the course of the year owes income taxes on the full amount, but his self-employment tax basis is $129,290, 92.35 percent of his gross earnings. He owes 15.3 percent on the first $106,800, or $16,340, and $652, or 2.9 percent of $22,490, on the remaining amount. His total self-employment tax is $16,992.
Income Taxes
Self-employed individuals are also assessed normal income taxes on their earnings in addition to owing the self-employed tax. The rate at which these earnings are taxed varies by a taxpayer's earnings, with those in the highest tax brackets paying a 35 percent tax rate. Continuing the example above, the taxpayer's $140,000 in earnings place him in the 28 percent tax bracket for 2010, which means he's liable for $32,900 in income taxes. That brings his total tax on self-employment earnings to $56,192.
Estimated Payments
To avoid penalties for underpayment, self-employed taxpayers must make estimated payments on all income earned through the year. These quarterly payments are roughly equivalent to payroll tax withholdings, and should be paid on each quarter's earnings, using normal income tax rates a taxpayer expects to be assessed as the basis for the tax. If a taxpayer over-estimates his tax burden, the IRS returns the overpayment as a refund.
