Yes, you should declare all your self-employment income

Between this blog and my travel hacking blog, at least 90% of my income comes from self-employment. I’m not even paid through a partnership or S corporation; I just get deposits into my checking account.

If you’re self-employed, it’s possible your income isn’t “tracked” in the way traditional wage income and some contractor income is, with the IRS receiving directly from your employer information about the amount paid and any taxes withheld. While digital employment platforms like Airbnb and Uber track income and report it to you and the IRS each year, self-employment marketplaces like Craiglist don’t.

That gives rise to the natural temptation to underreport or not report your income from self-employment in order to avoid the onerous self-employment tax. Here’s why that’s a terrible idea.

The self-employment tax is a pain in the ass

If you’re self-employed, the self-employment tax is 14.13% of your net self-employment income (for reasons I cannot begin to fathom, it is technically 15.3% of 92.35% of your net income). Most self-employed people after their first year of self-employment have to pay estimated taxes throughout the year, confusingly called “quarterly” estimated payments despite the fact that they are not due quarterly. Instead, they’re due on April 15, June 15, September 15, and January 15 (for the final four months of the previous year).

Estimated tax payments are collected through the very primitive EFTPS site, or there are a number of vendors that allow you to make estimated tax payments with credit and debit cards for a fee.

Importantly, the self-employment tax has nothing to do with the federal income tax, except that your self-employment tax obligations and payments are reconciled each year on IRS form 1040, along with your other tax obligations. Even very-low-income self-employed people owe the self-employment tax, although refundable credits may offset some of the self-employment tax when you reconcile them each year.

Self-employment taxes protect you from long-term disability

Each year in which you report earned income to the IRS, you earn work credits in the Social Security system. These entitle you to retirement benefits (more on that in a moment) but even more importantly for young and low-income workers, they entitle you to long-term disability benefits. You can earn up to 4 work credits per year (in 2016 you needed $5,040 in earned income to earn all 4), and depending on your age you need between 6 and 40 work credits to qualify for Social Security Disability Insurance. There are restrictions on how recently work credits have to be earned as well, which you can read more about here.

While older and higher-paid workers may have savings or private disability insurance to fall back on, for young and low-income people who are permanently disabled Supplemental Security Income and Social Security Disability Insurance are the two federal programs which provide cash income support. The key difference between the two programs is that Social Security Disability Insurance is only available if you’ve earned enough work credits to be considered “insured” by the Social Security system. It’s much more generous than Supplemental Security Income, which is a means-tested program with strict limits on income and assets.

The sooner you start working, the sooner you’re considered insured by the Social Security system. Unfortunately, many work-study positions at colleges and universities are not subject to Social Security taxes, and do not earn work credits towards insured status if you are enrolled full time. However, if you’re self-employed while enrolled in school, or do covered work during the year at another employer, your self-employment or FICA taxes will earn work credits towards insured status.

Self-employment taxes buy a good, cheap retirement annuity

Paying 14.13% of your income in self-employment taxes doesn’t feel great, but it’s one of the best investments ordinary people have available. There are a lot of intricacies in the system, but the logic of Social Security retirement benefits is simple and I want to lay it out as simply as possible. All the following figures are in 2015 dollars and are adjusted annually for inflation:

• The first $1,451 in self-employment taxes you pay each year buys a lifetime annuity of $22 per month starting at your full retirement age (67 for most younger workers). If you work for exactly 35 years, make $10,272 per year and retire at your full retirement age, you’ll have paid $50,785 in self-employment taxes and earn a monthly benefit of $770 until you die.
• The next $7,292 in self-employment taxes you pay each year buys a lifetime annuity of $39 per month, again starting at your full retirement age. A 35-year work history of $61,884 per year in earnings will have paid $306,047 and earn a monthly benefit of $2,146.
• Finally, each additional $1,000 in self-employment taxes (on $7,077 in additional income) you pay each year buys an additional lifetime annuity of $2.53 per month.

All of these calculations have been performed on self-employment taxes, but the logic is identical for employees, who only “see” half the taxes withheld from their income; their employer “pays” the other half.

Using this math, I know that since I paid about $3,100 in self-employment taxes in 2016, I’m entitled to an annuity of $31 per month starting at age 67 ($22 for the first $1,451 and $9 for the next $1,649). If my income keeps up with inflation, and I continue to dutifully pay my self-employment taxes, at age 67 I’ll have paid $108,500 for a $1,085, inflation-adjusted monthly annuity.

You have a stake in this system

Social Security disability and retirement benefits are the cornerstones of the American welfare state: they do more than any other program to support the poor and disabled, particularly among the elderly. But for a variety of historical and cultural reasons, they have to be “earned” through the regular payment of FICA taxes, in the case of employees, and self-employment taxes in the case of the self-employed. By reporting your self-employment income you may have less disposable income, although you may not if reporting your self-employment income triggers refundable tax credits like the Earned Income Credit. However, it entitles you to participate in these bedrock institutions that protect you and others from sickness and poverty.

The more you know about and participate in the Social Security retirement and disability system, the better equipped you are to defend it from its many enemies, whose agenda of reducing benefits and increasing poverty among the elderly is enabled by widespread ignorance about the program’s purpose and benefits.

For more on this topic, I recommend the excellent Social Security Works! by Nancy Altman and Eric Kingson.