The Self-Employment Tax: Into the Swamp
Posted by: John Tozzi on August 13, 2009
When reporters try to make stories short and clear, we sometimes sacrifice valuable detail and nuance. That’s easy to do when we write about taxes, because we also try not to put readers to sleep. A story I wrote earlier this week about how self-employed people pay an extra tax on health premiums that almost no one else in the system pays caused confusion among some readers, and I want to address that here. I’ll opt for detail and completeness instead of brevity. If you feel like diving deep into the the murky swamp of the tax code, read on after the jump. If not, I understand.
First, let me say that the self-employment tax is confusing even if you've paid it (which I have). It's important to remember that this is a separate tax from the federal income tax, even though you pay it on the 1040. Here's the big picture explainer behind it: Payroll workers have money taken out of their paychecks that pays for Social Security and Medicare, and that contribution is matched by their employers. Self-employed workers don't, and at tax time they have to pay both their own contributions and the employer contribution.
So most employees have payroll taxes (also known as FICA, for Federal Insurance Contributions Act) withheld from their paychecks along with their federal and state income taxes. The FICA tax goes to pay for Social Security and Medicare, and the worker's contribution is matched by an equal contribution from the employer (which since 1990 has been at the rate of 7.65% each, for a total contribution equal to 15.3% of the worker's salary). The Social Security portion of the FICA tax only applies to a certain threshold of income (up to $106,800 in 2009) while the smaller Medicare component applies to all income.
People who earn money through self-employment (instead of, or in addition to, wage and salary work) don't have these FICA taxes withheld, because they're paid as 1099 contractors, not W-2 employees. They also don't have an employer matching their contributions. But they still have to pay into the Social Security and Medicare funds. So at tax time (and really four times a year through estimated tax payments), they have to pay the full contribution of 15.3% on net earnings from self-employment. This is known as the self-employment tax (or SECA tax, for Self Employment Contributions Act). So self-employed people who earn the same as their wage and salary counterparts pay more in taxes, because they're on the hook for the employer's contribution to Social Security and Medicare. (We should note here that self-employed workers can take advantage of write-offs to lower their taxable income that payroll employees can't.)
It's true that, as with payroll workers, the self-employed contribution to Social Security stops at the income threshold of $106,800. (Not many freelancers I know are netting more than $100,000 these days, but then they're mostly reporters....)
It’s also true that self-employed workers can deduct one-half of what they pay in self-employment tax when they calculate their adjusted gross income for the purposes of paying income tax. However, that only lowers their AGI by the amount they paid in self-employment tax, shaving a bit off their income tax. They still pay more total (self-employment tax + income tax) than payroll workers who earn the same amount. This is explained in the IRS page we linked to in the second paragraph of the story.
Now, what about deducting health insurance premiums? For payroll employees who have health insurance through their jobs, their premiums are not taxed at all. The employer contribution is a business expense for the company, and any portion of the premium that the worker pays is taken out before taxes, so they don't pay FICA taxes or income tax on it. (Reader Robert Dolan makes the important point that part-time payroll workers who buy individual health plans because they're ineligible for employer coverage are also taxed on their premiums.)
Self-employed workers can deduct the costs of their health premiums from their income taxes, 100%. However, they cannot deduct premium costs when they calculate their self-employment tax liability. The IRS section on the Self-Employed Health Insurance deduction is very clear about this:
Effect on self-employment tax. Do not subtract the health insurance deduction when figuring net earnings for your self-employment tax.
This amounts to an effective 15.3% tax on health premiums for self-employed people that payroll workers and their employers don't have to pay. Lots of people think that's unfair, and since Congress is tackling health reform, they think fixing this should be part of it. I hope this clarifies things for the readers we've heard from who are unclear about aspects of the story. If not, reach me in comments below -- or talk to an accountant.