Higher Tax Cost for Self-Employment

Blog content provided by Barbara Weltman, Publisher of Big Ideas for Small Business ®

More people are becoming self-employed today, many spurred on because of job layoffs. Those who have long been W-2 workers and are new to self-employment may not be aware of the higher tax cost for self-employment. With federal and state income taxes, plus self-employment tax, the tax bill can reach nearly 50% of profits.

Here’s important information you’ll need:

• You pay Social Security and Medicare taxes (collectively called self-employment tax) on your net earnings from self-employment (your profits). The Social Security tax rate is 12.4% on net earnings up to a base amount ($106,800 in 2009); the Medicare tax rate is 2.9% on all net earnings. Thus, the total tax rate is 15.3%, one half of which is deductible. The self-employment tax applies without regard to what you do with your profits…reinvest in your business, pocket the money, or keep it in a bank (in contrast to an employee and his or her employer who only pay FICA taxes on compensation).
• Health insurance premiums for the self-employed and family are not deductible as a business expense to reduce profits subject to income and self-employment tax. They are deductible as an adjustment to gross income, so income taxwise, the result is the same; for self-employment tax, the result is more tax. For example, say a self-employed person pays $12,106 in health insurance premiums for the year (the average according to a Kaiser Family Foundation study for 2007. The person effectively pays $1,852 in self-employment tax that would not have been owed if the premiums had been deductible as a business expense. There have been Congressional proposals to change this tax treatment so that it equates with the treatment for corporations, but it is too early in this session to predict the likelihood of passage.
• Retirement plan contributions for the self-employed person are not deductible as a business expense, with the same tax results as for health insurance premiums.

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