Throughout its history, the United States has been the land of self-made men and women. But, the self-employed in the United States must deal with a unique burden every April 15 (on April 18 of last year): the self-employment tax. In addition to federal, state, and local income taxes, simply be the self-employed are subject to a separate 15.3% tax that covers Social Security and Medicare. While W-2 employees “split” this fee with their employers, the IRS considers an employer to be both the employee and the employer. Therefore, the higher tax rate.
The following six tips will help you make sure you don’t pay a penny more in self-employment tax than the law requires and keep as much of your hard-earned money as you can.
form an s corporation
Self-employment tax applies only to what the IRS calls “earned income,” that is, money paid to you as wages or salary. There may be reasons to consider forming an S corporation to save money, but they should consider other factors like having to form a board that they don’t have to under an LLC. However, it does not apply to dividends (or “unearned income”). The way to receive business income in the form of dividends is to create an S corporation. Nothing changes except that your customers or clients now pay the corporation instead of you directly. Instead, you start taking a salary from the corporation, but not a full salary. By paying 60% in the form of salary and 40% in the form of dividends, it will exempt that 40% from self-employment taxes.
As MyMoneyBlog He explains in his comprehensive breakdown of S-Corporation strategy, “the difference between a $90k salary vs. a $50k salary/$40k dividend is $6,000 a year” in tax savings.
Subtract half of your FICA taxes from federal income taxes
Entrepreneurs are also eligible to deduct half of their self-employment taxes from their federally Taxable income. Using the example above: Let’s say you owe $7,650 in self-employment taxes, which is 15.3% of the $50,000 salary your S corporation paid. Now you can, in turn, deduct $3,825 (which is half of $7,650) of your federal taxable income of $50,000. This way, the IRS can only tax $46,175 of your wages instead of the full $50,000. While it does not reduce your self-employment tax, it does reduce the total amount of tax you pay by reducing your taxable income.
Deduct eligible business expenses
The IRS allows business owners and business owners to deduct all “ordinary and necessary” business expenses. Here, “ordinary and necessary” is the operative phrase. You can’t take a trip to Hawaii and cancel it, for example, unless you actually went there to work. However, you can deduct anything used to generate your income: office space, supplies, advertising costs, business travel, even a prorated portion of your mortgage and utilities (if you maintain a home office). So, if you accumulate, say, $10,000 in business-related expenses during the year, you can reduce your taxable income from $50,000 to $40,000. Your self-employment tax liability will now be 15.3% of $40,000 (which is your net income) instead of $50,000 (which is your gross income).
Deduct health insurance costs
A substantial tax advantage that the self-employed have over employees is the ability to deduct health insurance costs. As the Balance explains, you can “deduct 100% of the health insurance premiums you pay for yourself and your qualified dependents,” as long as you made a net profit during the year. Like business expenses above, deducting your applicable health insurance costs reduces your taxable income for that year, which reduces the total dollar amount of taxes paid.
Defer income to avoid higher tax brackets
Another creative but perfectly legal way to reduce self-employment taxes is to defer income. As a self-employed person, you can choose whether you want to get paid now or later. While it may seem silly to delay receiving income, consider the following scenario. Let’s say that even after taking all legally allowable deductions, you’re still on track to have received $45,000 in net income for tax year 2023. By arranging to get paid even $276 of that in January 2024 instead of now or before the end of the year, your 2023 income will be taxed only at the income tax rates of 10% and 12%. None of it will be taxed in the 22% rate, as well as any salary amount between $44,726 – $95,375.
TurboTax has kindly posted the 2023 income tax brackets here. Take these into account and consider whether it might objectively make sense to defer some of your income. If you don’t need it right away, deferring income is a great way to reduce both your income taxes and self-employment taxes.
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