Self-Employment Tax
What it is:
The self-employment tax refers to the Social Security and Medicare taxes paid on income earned by people who work for themselves.
How it works/Example:
People who are self-employed must pay both the employee and employer portion of the Federal Insurance Contributions Act (FICA) tax (a total of 12.4% rather than the 6.2% normally paid by employees) and both halves of the Medicare tax (2.9% rather than 1.45% normally paid by employees). The self-employed can estimate these taxes using schedules C and SE of IRS Form 1040.
The self-employed usually pay self-employment taxes quarterly. The taxpayer's end-of-year tax return then determines if the payments were sufficient. The self-employed may still be required to pay self-employment tax even if they are receiving Social Security benefits.
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Why it matters:
Employees and employers normally split Social Security and Medicare taxes, but the self-employed are responsible for paying both portions of the tax. This tends to decrease the net income derived from self-employment, although half of the self-employment tax is generally deductible against the taxpayer's total income reported on IRS Form 1040.
Payment of these taxes makes the self-employed eligible for Social Security and Medicare benefits.