Hola, my tax-conscious compadres! Penny Taxwise here, back again with another installment of tax-tacular advice for your reading pleasure. This week, I chose an answered question from another Tax Connections member – the query was one I’ve pondered myself quite a bit lately. I want you to take a look at the original question before we get into the discussion portion of the program:

What is Self-Employment Tax and is this in addition to other taxes I pay as a small business owner at the end of the year?

This question is extremely relevant to my own situation – I’ve been doing the freelance writing thing for some time now, but this past year will be the first tax cycle I’ll have officially done it full-time (pause for applause). I myself have wondered how the whole tax thing should go down for the work-at-home crowd. I guess some part of me understood that my income taxes would be separate from the self-employment taxes I’d need to pay, but I was a bit fuzzy on the specifics.

Tax Pros to the Rescue

One of the dynamite Tax Connections gurus, Gary Carter, rushed right to the rescue with a fantastic (and not confusing – whew!) answer to the question. He’s the President of GW Carter, Ltd, Certified Public Accountants in Minnesota.

According to Carter:

Self-Employment tax is Social Security and Medicare tax for self-employed individuals. The rate is 13.3% of your self-employment net income for 2012 (10.4% for Social Security tax and 2.9% for Medicare tax).

Essentially, Carter’s saying that self-employment tax is the money that would be taken out of your paycheck automatically if you worked for an outside employer. When you work for yourself, your tax liability is the same as those who are externally employed, you’re simply responsible for paying into the system on your own.

Carter continued his answer by enlightening the asker about some upcoming changes to the tax code. “Beginning in 2013,” he says, “the rate for Social Security tax will increase by 2%, so the combined rate will be 15.3%.”

He also warns that self-employed individuals should be aware that their self-employment net income is the net income shown on Schedule C of Form 1040 – and not their taxable income. That’s why a self-employed person could have no taxable income yet still owe self-employment tax.

Make sense?

Yeah, it kind of confused me too. Luckily, Carter provided an example in his answer for those of us who need a little help wrapping our brains around this info. Gotta love those TC Tax Pros! Here’s what he said: “[L]et’s say your net income on Schedule C is $27,000 in 2012, and you are married filing jointly with two dependent children. Your taxable income is zero after your 4 exemptions and the standard deduction ($27,000 – ($3,800 x 4) – $11,900), but you will owe $3,591 in Self-Employment tax.”

That illustration really hit home for me because – jackpot – he described my exact tax situation. No joke. So now I understand – even though my income taxes will be zilch, I’ll still need to pony up a few thousand to cover my Medicare and Social Security. Makes sense… I’d better start padding the ol’ savings account before the tax man comes calling.

Bracing for the Blow of a Big Tax Bill

Now that we’re clear on the semantics of self-employment taxes, let’s shift the focus to footing the bill. Many self-employed people (cough, cough… myself included) fail to save adequately for the taxes that will inevitably find them each and every year they work for themselves. That’s why implementing some sort of system to set aside money for Uncle Sam is vital to protecting your bottom line – and your biz.

Once you pay self-employment taxes for the first time, you’ll be able to figure out roughly how much you’ll owe for the upcoming year. That is, unless you expect your income to sharply rise or fall. If you’re confident that everything will indeed stay consistent, however, then you have a solid figure with which to work.

Here’s my plan. I’m opening a dedicated savings account strictly for my tax savings. I won’t allow myself easy access to the funds – in fact, I’m planning to request that my bank limit my ability to transfer money from the account to my checking, if at all possible. I’ll dump a portion of everything I earn into the account – before I deposit the remaining money into my checking. If I overestimate my tax bill a bit one year, no problem. The leftover dough will be a great cushion for the following year’s bill.

Self-employment taxes are no joke, and neither is self-employment. I’m learning that the hard way. Without a boss hanging over your shoulder barking orders or a payroll department to neatly deduct taxes from your paycheck before you see it, it’s tough to regulate yourself. That’s why it’s so important to set up systems to regulate your business behavior. No one’s gonna catch you if you fall, so you might as well build yourself a net.

Until next time, my taxpaying friends!

Making Cents Count,

Penny