Running your own business or working an independent contractor gives you the freedom to be your own boss, but the Internal Revenue Service imposes special tax laws on self-employed workers. Self-employed workers often have high income potential that is only limited by the success of their business, but they may also face higher tax rates than traditionally employed workers.
Self-employment taxes (SE taxes) must be paid by all self-employed workers who make more than $400 in self-employment income in a year. According to the IRS, anyone who operates her own business or trade as sole proprietor, partner or independent contractor is self-employed. The Social Security Administration states that the self-employment tax rate is 15.3 percent in 2010 and that 12.4 percent goes toward Social Security, while 2.9 percent goes toward Medicare. This is double the amount of that normal workers pay toward Social Security and Medicare, because employers split the cost with employees.
While self-employed workers pay more for Social Security and Medicare, there is a limit on the total amount that must be paid toward social security. According to the SSA, the Social Security component of the SE tax only applies to the first $106,800 of income earned. Income earned beyond $106,800 is only subject to the 2.9 percent Medicare component of the SE tax.
Payroll Tax Cut
Legislation passed by congress in December 2010 will alter the SE tax rate going into 2011. According to the New York Times, a payroll tax cut was approved which will reduce the amount workers pay toward Social Security by 2 percentage points; normal workers will pay 4.2 percent of income toward Social Security starting in 2011 while self-employed workers will pay 10.4 percent. The tax cut does not affect the Medicare tax rate.
Normal employees have money withheld from paychecks to pay for income taxes, Social Security and Medicare. Self-employed workers must submit estimated tax payments to the IRS on a quarterly basis to cover SE tax owed as well as their normal income taxes (self-employed workers face the same federal income tax rates as any other worker.). Failure to make estimated payments can result in tax penalties when you file a tax return at the end of the year.