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Independently Financed

Yes, you should declare all your self-employment income

February 7, 2017 by indyfinance 12 Comments

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.

Filed Under: self-employment

Reader Interactions

Comments

  1. Joe says

    February 7, 2017 at 10:24 pm

    Lol I didn’t even realize it was you 😀

    Reply
  2. Jamie says

    February 8, 2017 at 12:13 am

    Nice article, thanks!
    I’m very much in the camp of the generally well educated, but fairly ignorant on personal finance matters. Looking forward to this blog!

    Reply
  3. Dave says

    February 10, 2017 at 5:40 pm

    Bravo for raising this important topic. While it is tempting to use every available deduction to reduce our taxable business income, there is a downside. When I moved from W2 to 1099 income, my Social Security benefits (estimated) declined significantly. Now I make sure to leave some deductions untaken, pay my self-employment tax and hope that the politicians don’t break Social Security!
    BTW, the effective self employment tax rate is lower than 14% because the business income is reduced by the “employer” portion of the self employment tax

    Reply
  4. plane2port says

    February 11, 2017 at 11:00 pm

    This is a great post and your potential social security benefit is something to keep in mind in your financial planning. Many young people have a fatalistic attitude about social security–they think that the system won’t be viable when they reach the age to collect. But that day gets here sooner than you think! I learned about all this the hard way.

    Before taking a job as a teacher in a public school system I had previously worked for enough quarters in private industry and as a self-employed person to be able to get a social security benefit. The school system where I worked had opted out of social security long before I started working there. I knew that I wasn’t paying in and that my benefit would not increase, but I still though I would get the benefit based on my past work.

    Then one day we had a system-wide meeting where the financial office informed us of the IRS’ Windfall Profits Elimination provision. If you qualify to receive a pension from an employer who has opted out of the system, you are penalized for not having payed in! The penalty works out to about 50% of the monthly benefit that you would get if you had paid into Social Security for the whole time.

    I was still able to retire early, but if I had known about this before taking the teaching job I might have planned things a little differently.

    Reply
  5. For the family says

    February 12, 2017 at 7:11 am

    Wow, presuming Social Security is still paying out in 25 years for myself:

    1. The first set $50,785 paid yields $770 per month, which is $9240 per year, meaning that after 5.5 years of collecting, you will be getting more than you paid in. So if it’s likely you’ll live past 71.5, this is a money maker! Huh! This is a good sales pitch. Guess I might make sure to earn at least 10K annually, (which interestingly coincides with EIC peak rates).

    2. $306,047 paid yields $2146 monthly, or $25,752 annually: 11.88 years of collecting to break even. Hmm, not as good of a deal, but reasonable.

    I wonder how taking early retirement would effect these numbers, as taking early retirement increases your number of years collecting.

    I wonder

    Reply
    • Ben says

      February 24, 2017 at 1:24 am

      You are forgetting one important part. any money you pay in taxes now, is money you could have invested. even at a moderate 5% yearly yield it would take whole a lot more years to make up for that

      Reply
  6. nyc seo says

    February 15, 2017 at 10:18 am

    You have good info on the site. But it won’t load on Safari for some reason.

    Reply

Trackbacks

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    February 10, 2017 at 12:09 am

    […] By excluding income on capital from FICA (Social Security and Medicare) taxes Congress encourages holding securities instead of starting your own business, which would be subject to self-employment taxes. […]

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  2. The effects of late-career Social Security contributions - Independently Financed says:
    March 16, 2017 at 12:48 pm

    […] I’ve written before (and expect to write more) about the Social Security Administration, which is both the primary source of disability insurance for low-income workers and one of the lowest-cost guaranteed retirement savings vehicles available to all workers in the United States. […]

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  3. The SECURE Act and the defects of the centrist mind - Independently Financed says:
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