Self-Employment Tax: Definition, How It Works, and How to File

What Is the Self-Employment Tax?

The term self-employment tax refers to taxes self-employed individuals and small business owners pay to the federal government to fund Medicare and Social Security. The self-employment tax is similar to Federal Insurance Contributions Act (FICA) tax paid by employers. This tax is due when an individual has net earnings of $400 or more in self-employment income over the course of the tax year or $108.28 or more from a tax-exempt church. The tax is computed and reported on IRS Form 1040 Schedule SE. Individuals who make less than these thresholds from self-employment don’t have to pay any tax.

How the Self-Employment Tax Works

The self-employment tax is designed to be collected from workers who are considered self-employed and don't otherwise pay withholding taxes. This includes sole proprietors, freelancers, and independent contractors who carry on a trade or business. A member of a partnership that carries on a trade or business may also be considered to be self-employed by the Internal Revenue Service (IRS). Self-employed individuals must pay self-employment tax as a condition of receiving Social Security benefits upon retirement.

In any business, both the company and the employee are taxed to pay for the two major social welfare programs: Medicare and Social Security. In the eyes of the IRS, individuals who are self-employed are considered both the company and the employee, which is why they must pay both portions of this tax. Here's how it works.

Social Security tax is assessed at a rate of 6.2% for an employer and 6.2% for the employee. Therefore, a self-employed worker is taxed 12.4% (6.2% + 6.2%) as they are considered to be both an employer and an employee. The Social Security tax is only applied to the first $147,000 of self-employment income earned, for a maximum tax of $18,228 in 2022. That amount increases for 2023 and is only applied to the first $160,200 of income for a total tax of $19,864.80.

Medicare tax is assessed at a rate of 1.45% for an employer and 1.45% for the employee. Therefore, a self-employed worker is taxed 2.9% (1.45% + 1.45%) as they are considered to be both an employer and an employee. There is no income limit for Medicare taxes. Total self-employment tax rate 15.3% (12.4% + 2.9%). A self-employed person with a total net income of exactly $137,700 in 2022 would have to remit taxes of $21,068.10 ($137,700 x 15.3%).

Special Considerations

Workers who are self-employed aren’t subject to the withholding tax. As such, the IRS requires taxpayers to make quarterly estimated tax payments in order to cover their self-employment tax obligation, in addition to their federal and state income tax obligation.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law by President Donald Trump on March 27, 2020, deferred payment of the employer portion of self-employment taxes attributable to Social Security for the period of March 27, 2020, through Dec. 31, 2020. It deferred payment of 50% of those taxes until Dec. 31, 2021, and the other 50% until Dec. 31, 2022.

Example of the Self-Employment Tax

Contrary to what you may think, individuals typically pay self-employment tax on 92.35% of their net earnings—not on 100% of their full earnings. Here's how it works.

Let's say an individual runs a human resource (HR) consulting business and calculates their total net income for 2022 as $200,000 after business expenses are deducted. Their self-employment tax will be assessed on 92.35% of this amount $200,000 for a total of $184,700. This amount is above the capped limit for the Social Security portion of the self-employment tax. Therefore, Robin's self-employment tax bill will be $23,063.50. We arrive at this figure as:

($142,800 x 12.4%) + ($184,700 x 2.9%)

$17,707.20 + $5,356.30

When filing their 2022 income tax return, they can claim an above-the-line deduction for half of their self-employment tax, or $23,063.50 ÷ 2 = $11,531.75. In effect, they get a deduction on the employer portion (6.2% Social Security + 1.45% Medicare = 7.65%) of their self-employment tax.