If you’re assuming that your business will pay the same amount in taxes that you did as an employee, surprise! You’re going to pay more.
But why?
You Pay Employer + Employee Taxes
When you work for an employer, your taxes are automatically deducted from your paycheck. (Which likely includes income tax, social security, and Medicare.)
What you don’t see is that you’re only paying half of your social security and Medicare taxes. Your employer pays the other half.
When you’re self-employed, you are both the employer and the employee, so you pay both halves.
Click here for more info on the social security and Medicare tax rate.
Remember: This doesn’t include income tax. You have to calculate that rate based on how much you earn.
Watch the Short!
How to Pay Quarterly Taxes
While you pay these taxes each pay period as an employee, when you’re self-employed, you have to manually make these payments to the IRS quarterly. Not paying what you owe quarterly can lead to late fees. I make my payments here.
But pay attention to the schedule, IRS quarters are wack.
And always make sure to calculate your taxes on NET INCOME. This is your gross income minus your qualifying expenses.
How to Reduce Your Tax Liability
Deductions, AKA “write-offs”
These are necessary business expenses such as office supplies, equipment, software, marketing, employee wages, etc., but also includes mileage and a home office.
What I’m Writing Off From My Pilates Teacher Training Weekend →
How Deductions Work
Many business owners assume that deductions reduce their tax liability at a 1:1 ratio, meaning that every $1 spent reduces their taxes by $1.
Deductions reduce the income your business is taxed on, not the taxes themselves.
For example, let’s say my business earns $2,000 this month and my deductions were $1,500.
$2,000 gross income
- $1,500 deductions
= $500 net income
My business would be taxed on the net income of $500. The tax rate I pay is 30%, meaning my taxes would be $150.
Actual Scenario = $150 taxes
*Note that taxes are actually payed quarterly (and that IRS quarters are whack), and the mileage deduction is taken at the end of the year when you file your tax return.
Psst! Wondering why self-employment taxes are so expensive? Read this.
Let’s run the numbers again with the assumption that the deduction reduces the taxes owed at a 1:1 ration:
$2,000
x 30%
= $600
$600 taxes
- $1,500 deductions
Incorrect 1:1 Ratio Scenario = - $900 taxes
Note the negative here. The IRS doesn’t want to owe you money, which is why deductions reduce the income your business is taxed on, not the tax amount you owe.
Credits
Unlike deductions, credits reduce taxes owed at a 1:1 ratio.
Contributing to a SEP IRA or Solo 401(k) and even HSA contributions count as credits.
Benefits You Can Get Through Your Business →
Including up-to-date contribution limits!
Because the tax benefits are better than deductions and because I value saving for retirement, I prioritize contributing to my HSA and SEP IRA.
TL;DR
Self-employment taxes are more expensive than employment taxes because you’re covering the employer and the employee portion of the social security and Medicare tax.
You can, however, reduce what you owe in taxes through business expenses (deductions/write-offs) and offering yourself benefits (credits). Just be mindful of deductions, because they don’t reduce your tax liability at a 1:1 ratio. Credits do.
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Just getting started in business and looking for a roadmap? Check out my Begin Your Business online course. We’ll cover everything from pricing to forming an LLC, assembling your team to getting your first clients, and everything in between.
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Disclaimer: I am not an attorney, certified public accountant (CPA), or financial advisor. I help entrepreneurs become more confident in starting and growing their businesses through how-to’s and advice that I have learned from experience. All information on this site is for educational purposes only and should not be taken as prescriptive direction. If you need additional help, I highly recommend reaching out to an attorney, certified public accountant, financial advisor, or business advisor to help advise you on your specific journey.
