As a self-employed individual, you are entitled to social security and Medicare benefits, just as are employees, but you need to calculate your net earnings, report them on Schedule SE when you file your annual U.S. federal income tax return, and pay the corresponding tax. You may need to make estimated tax payments during the year. If you have a loss or only a small net profit from self-employment, but you want to ensure that you get the necessary credits for social security coverage benefits, there are optional methods you can use to calculate your self-employment tax.
What is the self-employment tax?
The Self-Employment Tax is the social security and Medicare tax that applies to people who work for themselves, rather than as employees. It is equivalent to the FICA (Federal Insurance Contributions Act) tax withheld from the pay of employees. Self-employed workers are also entitled to social security and Medicare coverage and benefits, but they must calculate this tax themselves, based on their net earnings from self-employment, and pay the tax together with their federal income tax payments.
The social security portion of the tax, which applies up to a maximum amount of net earnings from self-employment each year, covers old-age, survivors and disability insurance; and the Medicare portion, which applies to all net earnings without limit, covers hospital insurance.
Employees have this tax withheld from their paychecks, with a corresponding payment from their employers as a payroll tax. Self-employed workers are responsible for the entire amount of the social security and Medicare tax, but there is a provision in the federal income tax law that allows self-employed individuals to deduct one-half of their self-employment tax as an adjustment to their income for U.S. federal income tax purposes. This reduces net income subject to income tax. It affects only the federal income tax and does not affect net earnings from self-employment or the self-employment tax.
How are social security benefits affected?
Social security coverage is based on obtaining the required number of credits, called quarters of coverage. One credit, up to a maximum of four for the year, is received for a certain quarterly amount of income subject to social security taxes, or self-employment tax, in this case. This amount is subject to change each year. If you have a total of four times the quarterly amount in income subject to social security tax (from self-employment or wages) in a year, you receive the four credits for the year. So, provided that you have earnings from self-employment and you report and pay self-employment tax on these earnings, your social security coverage will be the same as it would have been if you had worked as an employee and had the tax withheld from your pay.
If you have been self-employed but have not reported and paid the self-employment tax, you can still report and pay the tax in order to obtain the corresponding credits for social security coverage. But the Social Security Administration has a 3-year time limit for posting self-employment income. If you file a return for a previous year, you will most likely be assessed a late filing penalty, but you would be able to recover the credits for purposes of determining your future social security benefits.