What the Self-Employment Tax Means for Freelancers

Benjamin Franklin had it right when he said, “The only things certain in life are death and taxes.” However, for freelancers who have to deal with unusual streams of income that are taxed differently from full-time earnings, the trick is to avoid death because of taxes.

Although freelancers enjoy the benefits of receiving income that isn’t taxed right away, a lot of the confusion that comes up in April stems from an extra 7.65 percent burden self-employed contract workers must pay. Being your own boss may be freeing, but as long as the government exists, being your own boss will never be free.

What is the self-employment tax?

The self-employment tax began in 1951 to help fund Social Security. Workers were charged 2.25 percent. Clearly, things have changed.

Now, the self-employment tax consists of Social Security and Medicare taxes. Everyone in the workforce needs to pay the usual 7.65 percent. However, if you’re an independent contractor or business owner, an additional 7.65 percent is required to cover the amount otherwise taken care of by an employer. In total, the self-employment tax is 15.30 percent of net self-employment income.

Who needs to pay self-employment tax?

You must pay the self-employment tax if the following scenarios apply:

• You are paid by a client/employer via Form 1099-Misc
• You do not receive a W2 from an employer
• Your net earnings from self-employment are $400 or more

How to minimize your effective tax rate

The effective tax rate is defined as the average rate at which an individual or corporation is taxed, and unfortunately, freelancers often pay the highest effective rate because of the self-employment tax. It is incredibly important to take advantage of deductions. Some common deductions include advertising costs, home office purchases, insurance, travel, and business-related meals. As a freelancer, you will be filling out a Schedule C tax form. Understanding the tax form and the related deductions will help to minimize your effective tax rate.

How to tax plan

The only sure-fire way to reduce tax liability is to maximize your business expenses. Many people don’t think about taxes until it’s tax season. However, the way to really minimize your tax liability is to plan far in advance by tracking all expenses and business receipts. Create a spreadsheet to monitor your budget and freelance income. This way you’ll know your deductions at all times. And since you only pay taxes on your profits, minimizing your profit is another key to successful planning. If you’re showing a large profit at the end of the year, make those big purchases—computers, phones—to maximize your deductions.

Retirement accounts are also important options as tax shelters. Talk to a wealth advisor about opening an IRA (Individual Retirement Account) or SEP IRA (Simplified Employee Pension) before the tax year ends. Save a little money each month and make the contributions necessary to lower your overall tax liability. In 2013, one could contribute a maximum of $5,500 to an IRA and the lesser of 25 percent or $42,000 for a SEP.

Be more like Mitt (sort of)

It’s probably safe to assume most people do not want to emulate Mitt Romney—unless they’re interested in compiling binders full of women. But, no matter what your political affiliation is, taxes can put a vice grip on your wallet, and Romney happens to be an excellent tax planner. His effective tax rate in 2013 was close to 14 percent, and he understands the tax code and related loopholes. Regardless of how much money you earn, it’s important for you to do the same.

Somya R. Munjal owns CPA for the People, which is dedicated to providing affordable accounting services to freelancers, artists, and start-ups. She also helps Contently, Inc with their finance function.