About This Episode
When you’re self-employed tax season is TOTALLY confusing and overwhelming. Today, we’re talking about how self-employed people are taxed, learning about income tax and self-employment tax, and discussing how much you should set aside for quarterly taxes.
What We’re Talking About
- How Are Self-Employed People Are Taxed?
- Understanding Income Tax When You’re Self-Employed
- How To Calculate Self-Employment Tax
- How Much Should You Save For Quarterly Taxes?
How Are Self-Employed People Are Taxed?
Despite the legal differences, sole proprietors and single-member LLCs are taxed the same by the IRS. That’s because single-member LLCs are considered disregarded entities by the IRS.
Does that mean that your LLC isn’t legit? Nope! You still get all the liability benefits of an LLC, but the IRS doesn’t consider an LLC a taxable entity. Instead, it gives your LLC a default tax classification, which is sole proprietorship.
When you’re taxed as a sole proprietor all the profits from your business are passed on to you, the owner. That means your business doesn’t pay taxes on its profit. This is unlike a C corp, which pays taxes on its profits at the corporate tax rate.
When your business’s profits are passed on to you, the owner, you personally pay taxes on your business profits. You report your business’s income, expenses (aka tax deductions), and net profit or losses on the Schedule C of your personal tax return, Form 1040.
Then, you’ll pay two types of taxes: income tax and self-employment tax.
Understanding how the IRS classifies you is critical so you can be well prepared come tax season.
Understanding Income Tax When You’re Self-Employed
When it comes to income tax, it’s impossible to give a one size fits all explanation. There are many factors that contribute to what you owe, including your business income, other forms of income (like a side hustle or W2 employee income), filing jointly with a partner, and personal deductions.
Once you know your adjusted gross income, you can determine which tax bracket you are in. From there, you can use a tax table to estimate your payment to the IRS.
How To Calculate Self-Employment Tax
Luckily, self-employment tax is much more straightforward than income tax. Self-employment tax covers Social Security and Medicare and is based on your net business income. You pay self-employment tax on most of your business’s net profits (92.35% to be exact).
So how much is self-employment tax? A cool 15.3%. Bummer, I know.
So why are your taxes so much higher when you’re self-employed? Because your footing the entire bill for your Social Security and Medicare (which, remember, is what your self-employment tax covers.
When you’re an employee, you and your employee pay FICA payroll taxes which go towards your…Social Security and Medicare. FICA payroll taxes are 15.3% of your gross wages (are you noticing a pattern?). BUT, as an employee, your employer pays for half of your FICA payroll taxes (7.65%) and you have the other half (7.65%) withheld from your paycheck.
But, as a self-employed person, you pay the entire 15.3% yourself.
To calculate your self-employment tax the easy way, just multiply your net profits by 15.3%. Voila– that’s a quick estimate of your self-employment tax.
To get more detailed, first, figure out what 92.35% of your total net profits is and then multiply that number by 15.3%.
How Much Should You Save For Quarterly Taxes?
The question of all questions: How much money should I put aside for my taxes?
There are a few ways to estimate what you’ll owe. If your finances will be similar to last year, you can base estimations off those numbers. Simply take your total tax bill from last year and divide it by four to calculate your quarterly tax payments.
You also can speak to a tax preparer who is familiar with your personal financial situation. They can help you project what you might owe based on your personal tax situation. And if nothing else, they can help you come up with a tax savings percentage that is appropriate for your business.
If all else fails, a good rule of thumb for quarterly taxes is 25-30% of your net income.
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