Working for yourself can be rewarding, but it can come with sticker shock come tax time. If you're used to working as a W-2 employee, you might be surprised to discover that your tax liability significantly increases when you're self-employed.
The reason is FICA taxes. FICA taxes include Social Security (12.4%) and Medicare (2.9%) for a combined 15.3% tax.
As a W-2 employee, you pay half of your FICA taxes (7.65%) through payroll deduction, and your employer pays the other half.
Here’s the bad news: When you are self-employed, there is no payroll deduction and no employer to pay half of the FICA tax—you're responsible for the total amount. This so-called self-employment tax applies to anyone who earns income as a sole proprietor, freelancer, gig worker, or independent contractor.
The Good News
The good news is that you only pay self-employment tax on your net earnings. Net earnings are your total income from self-employment minus your business expenses. You are not subject to self-employment tax if your net income is less than $400 or you have a net loss.
Typically, you can deduct a net loss from your gross earnings – thus limiting your tax liability.
You can further reduce your tax liability by deducting certain business expenses. For example, if you use a vehicle for business, a portion of its cost can be deducted. Similarly, a portion of your rent or mortgage can be deducted if you have a home office. Other common deductions include health insurance premiums, retirement plan contributions, and equipment depreciation.
You can also deduct half of the self-employment tax. The IRS allows you to deduct the employer-equivalent portion of your self-employment tax (7.65%, representing half the total 15.3% tax rate) from your income, further reducing your tax liability.
Avoiding Sticker Shock
When you’re self-employed, you must file an annual income tax return and pay estimated taxes quarterly. This means you need to estimate your income for the year and make four equal payments of that estimated amount throughout the year. Planning is necessary to ensure you have enough money to make your quarterly payments.
Tax codes and deductions are complicated and confusing, and making estimated quarterly payments can be time-consuming. It’s easy to overlook available deductions and miss important deadlines. After all, most self-employed people are too busy managing their businesses to keep up with all the tax rules and deadlines.
That’s where Fischer Advisors can help. We are a full-service tax and accounting firm offering tax, accounting, payroll, and advisory services tailored to your business's specific needs. Our team is here to help you take advantage of the business deductions you are entitled to and assist with your quarterly estimated payments – saving you money in the long run.