A Guide to Understanding Self-Employment Tax

If you own a growing, unincorporated small business, you may be well-acquainted with the challenge of high self-employment (SE) tax bills. The SE tax serves as the mechanism for collecting Social Security and Medicare taxes from self-employed individuals. Here’s a refresher on how it works and strategies for managing its impact.

SE Tax: The Basics

The self-employment tax rate is currently 15.3%, which applies to the first $168,600 of your net SE income for 2024. This rate is divided into two components:

• 12.4% for Social Security
• 2.9% for Medicare

For 2025, the threshold increases to $176,100, but the structure remains the same: above this amount, the 12.4% Social Security component drops off, while the 2.9% Medicare tax applies to all income.

Calculating Your SE Tax

To determine your SE tax:

1. Calculate your net self-employment income, which is generally 92.35% of your taxable income from self-employment activities (reported on Schedule C of Form 1040).
2. Apply the appropriate rates:
   • For income at or below the threshold ($168,600 in 2024), multiply the amount by 15.3%.
   • For income exceeding the threshold, calculate:
     • 12.4% of $168,600, plus
     • 2.9% of your total net income.

Example: If your net SE income for 2024 is $200,000, your SE tax would be:

• $20,906 (12.4% of $168,600), plus
• $5,800 (2.9% of $200,000).
  This totals $26,706—a significant amount!

Future Projections for SE Tax

The Social Security tax ceiling is subject to annual inflation adjustments, which means the burden of SE tax is likely to grow over time. According to recent projections by the Social Security Administration, the tax ceilings for 2026–2033 are expected to rise significantly:

• 2026: $181,800
• 2030: $213,600
• 2033: $242,700

If these projections hold, the SE tax on $242,700 of net income in 2033 could reach $37,133 (15.3% of $242,700).

Misalignment Between Tax and Benefit Increases

It’s important to note that rising SE tax ceilings aren’t matched by equivalent increases in Social Security benefits. This disconnect occurs because different inflation measures are used:

• The tax ceiling is adjusted based on wage inflation.
• Benefit increases are tied to general inflation.

For example, in 2024, the Social Security tax ceiling increased by 5.24%, but benefits rose by only 3.2%.

Exploring Strategies to Reduce SE Tax

One effective way to manage SE tax is to consider restructuring your business as an S corporation. With this approach:

• You can pay yourself a modest salary subject to Social Security and Medicare taxes.
• The remaining income can be distributed as dividends, which are not subject to SE tax.

This strategy can significantly lower your SE tax liability, although it requires careful planning and compliance.

Need Help Navigating SE Tax?

Managing self-employment tax can be complex, especially as thresholds and rates change over time. If you have questions or need guidance on strategies like the S corporation approach, reach out to us for personalized advice tailored to your business needs.