Being your own boss, setting your own hours, enjoying the full fruits of your labor without interference from meddling middle managers and corporate overlords — that's the self-employed dream!
But there are trade-offs for all of that freedom and autonomy. You don't have a dedicated human resources staff to manage your 401(k) contributions, withhold federal and state income taxes, or help pay for unemployment benefits. When you're self-employed, you have to juggle all of those responsibilities yourself — or make enough money to hire an accountant to do it for you.
The self-employment tax is a great example of one of the trade-offs that comes with working for yourself. If you get a regular paycheck from an employer, you probably noticed those deductions labeled "FICA – Social Security" and "FICA – Medicare." FICA stands for the Federal Insurance Contributions Act, which requires every American worker to pay into the Social Security and Medicare trust funds in order to claim benefits upon retirement.
For 2014, the total cost of FICA contributions is 15.3 percent of earned income. If you work for someone else, your employer pays half of your FICA contributions (7.65 percent), and you're on the hook for the other half. If you are self-employed, however, you need to pay the entire 15.3 percent yourself [source: IRS]. That, my friend, is called the self-employment tax.
In truth, the self-employment tax isn't some kind of punishment for independent workers and small business owners. Its sole function is to make sure that self-employed people are covered by the same "safety net" insurance as salaried workers. By making FICA contributions on your earnings, you earn credits in the Social Security system, allowing you to claim a monthly benefit throughout retirement [source: SSA]. The same is true for Medicare benefits. By paying self-employment tax, you are covered in your golden years.
So how exactly do self-employed folks calculate their self-employment tax, and is it true that you have to pay estimated taxes four times a year? Let's start by defining who fits the description of "self-employed" according to the only source that matters: the IRS.