SELF EMPLOYMENT TAX VS FICA TAX
All workers are required to pay into the Social Security system – unless you work for the government or some non-profit organizations. Employees have FICA (Social Security and Medicare) Tax withheld from their wages. Employers must match the amount withheld. Individuals with “net earnings from self-employment” pay the Self-Employment Tax – which is actually FICA Tax. However they must pay “both halves” of the FICA tax (the equivalent of the employee’s share and the employer’s share).
In reality self-employed individuals actually pay only 14.13% on “net earnings from self-employment”, as the 15.3% is only applied to 92.35% of their net Schedule E (or K-1) earnings. Plus they are allowed an “above-the-line” deduction for ½ of their Self-Employment Tax – so the actual effective tax rate depends on their federal income tax rate. taking into account the 50% self-employment tax adjustment to income, the “effective” cost of your self-employment tax is –
* 15% Bracket = 13.07%
* 25% Bracket = 12.36%
* 28% Bracket = 12.15%
The “Fix The Tax Code Friday” topic at Kelly Phillips Erb’s TAXGIRL blog today is “Fix the Tax Code Friday: SE Tax”. She asks the question – “Should self-employed persons be allowed to opt out of paying self employment tax (and thus, collecting Social Security benefits and the like)?”.
In my comment on the question submitted at TAXGIRL I said that “My answer is yes – but only if “normal” W-2 employees were similarly able to “opt out” of Social Security. As long as one class of worker is required to participate it should be mandatory for all classes.
I also support private Social Security accounts – not invested in the stock market, but in the money market or Treasury securities market.”
If I was able to invest all the money that I paid into the Social Security system over the years, and all future payments, in a 5% money market account or bank CD I would have a lot more money at retirement than I will be collecting from Social Security.
In addition – if I apply for Social Security and get my first check and then drop dead the next day, all the money I paid into the system will not go to my beneficiaries but to other SS recipients. All the money will be lost! If I had instead invested the money in a private account the balance would pass on to my sister and other relatives.
My comment goes on to say – “The self-employment tax calculation should be corrected to bring it in line with the treatment allowed a one-man corporation. In a one man corporation all employee benefits provided to the owner, like health insurance and pension contributions, reduce {the money available to pay} the owner’s salary. FICA tax is only assessed on the actual salary.
With a self-employed individual, the SE tax is imposed on net profit of the business before deducting the self-employed health insurance premiums and pension contributions for the self-employed person and the ½ of SE tax.
Owner health insurance premiums and pension contributions should be Schedule C deductions and not adjustments to income.”
In the case of two self-employed individuals with the exact same income and expenses – one filing Schedule C and one incorporated – the Schedule C filer will pay a lot more in Self-Employment Tax than the incorporated business owner will pay in employee and employer FICA tax. Is that fair?
So how would you answer Kelly’s question – and what do you think of my suggestions?
Tax Forms, Complexity, and Tim Geithner
People often measure our tax system’s complexity by counting tax forms as if the documents, not the law, are the culprit. But my former IRS colleagues used to remind me that forms actually help taxpayers. Imagine if people were required to read the Internal Revenue Code to figure out how much they owe.
This truism leapt to mind when I read about Treasury Secretary-designate Tim Geithner’s tax problems. While employed at the IMF, Geithner failed to report liability for about $34,000 in payroll taxes. After the IRS audited his 2003 and 2004 returns, he paid the back taxes with interest. Recently, he also remitted payroll taxes for 2001 and 2002, even though by then the statute of limitations had expired.
For most workers, paying payroll taxes is simple because employers withhold both the employee and employer portions. Self-employed people and those with income from partnerships or farms must report their incomes on Schedules C, E, or F. Those forms have a line for payroll tax (called self-employment tax) and refer taxpayers to a Schedule SE to compute this tax. Tax software performs these calculations, completes Schedule SE, and reports the tax owed automatically.
But employees of international organizations (and some others, including clergy) live in a tax never-never land. Their employers aren’t required to pay
Here’s where the fun begins. There is no place to remit this payroll tax on Form 1040, where employees report their wages. Instead, the employee must complete Schedule SE even if he has no self-employment income or any other reason to complete a schedule (C, E, or F) that would direct him to Schedule SE.
Ready for some more fun? Line 2 of Schedule SE lists the types of income that must be reported for SE tax and also specifies: Ministers and members of religious orders, see instructions for amounts to report on this line. Who would guess that these instructions also apply to
As the Senate Finance Committee report on the Geithner matter states, the IMF prepares a booklet for its employees detailing their tax responsibilities and sends its U.S. employees quarterly wage statements that show how their earnings are grossed up to cover the cost of state and federal income taxes and payroll taxes they must pay. So Mr. Geithner had a lot more to go on than just the IRS tax forms. Still, the chances of an error would have been lower if the tax forms had clearly pointed to the right result. And I and some of my colleagues who have consulted for the IMF have ourselves been confused about whether to report our IMF income as wages or self-employment income for tax purposes, with some of us “tax experts” paying too much self-employment tax in past years.
No tax form can clarify every possible wrinkle in the tax code, and the number of taxpayers involved probably doesn’t warrant a special form for income from international organizations or another line on the 1040. But it is not hard to see why we need so many tax forms.
Maybe, however, there is some benefit to this embarrassing episode. Having stumbled in the overly complex maze that is the Internal Revenue Code, maybe Treasury Secretary Geithner will have some sympathy for those who want to simplify it.