Self-Employment Tax

The Self-Employment Tax is how an independent contractor pays Social Security and Medicare payroll taxes. In the case of employees, the employer and employee split the cost of these payroll taxes, each paying 7.65% of eligible wages. An independent contractor, by contrast, is both the employer and the employee, so a self-employed person pays both halves, or 15.3% total. The tax is composed of a Social Security tax of 12.4% on the first $106,800 of net self-employment income (for 2009 through 2011), and a Medicare tax of 2.9% on all net self-employment income. For the year 2012, Social Security taxes are assessed on the first $110,100 of net self-employed income. For Social Security wage limits for other years, see the article What is the Social Security Tax?

Self Employment Tax Reduction for 2011 and 2012

For the years 2011 and 2012, the self-employment tax is reduced. Self-employment persons will pay Social Security tax of 10.4% on the net self-employment income up to the Social Security wage base of $106,800, and the same 2.9% Medicare tax on their total self-employment income. Self-employed persons will take a deduction for the 6.2% employer's share of Social Security along with 1.45% employer's share of Medicare as an above-the-line deduction.

Strategies to Reduce the Self-Employment Tax

The self-employment tax is basically a percentage of your net income from self-employment activities. The only way to reduce your self-employment tax is to increase your business-related expenses, as this will reduce your net income, and corresponding reduce your self-employment tax. Regular deductions, such as the standard deduction or itemized deductions, won't reduce your self-employment tax. Similarly, adjustments to income for health insurance, SEP-IRA contributions, or solo 401(k) contributions will not reduce your self-employment tax either; those deductions only reduce your income tax. One tactic to examine when preparing your tax return: the impact of taking the Section 179 deduction or bonus depreciation for fixed assets on both your regular tax and self-employment tax.

Strategies to Increase the Self-Employment Tax During Years with Losses or Very Low Income

Sometimes a person wants to increase their self-employment tax to maintain their eligibility for Social Security retirement or disability benefits. In general, people need at least forty Social Security credits over their lifetime to be eligible for retirement benefits, and at least five years of credits out of ten to be eligible for disability benefits.

Self-employed people who are facing a year in which they have lost money (expenses greater than income) or years in which their income is vastly lower, and who still want to build up Social Security credits towards their retirement or disability benefits, can use a special method to increase their self-employment tax. This is called the "Optional Method" and the rules are spelled out in the Instructions for Schedule SE (pdf file).

What's important to remember is this: self-employed persons who are not farmers or fisherman are limited to using this optional method only five times in their lifetime.