Net Earnings: Self-employed Taxes Explained + Definition

Net earnings refer to the income that a self-employed individual makes after deducting all business expenses. This is the amount that is subject to self-employment taxes. Understanding the concept of net earnings is crucial for self-employed individuals as it forms the basis for calculating their tax obligations.

Self-employment taxes are taxes that self-employed individuals pay to the federal government in the United States. These taxes contribute to Social Security and Medicare funds, which are typically paid by both employers and employees in traditional employment settings. As a self-employed individual, you are considered both the employer and the employee, hence you are responsible for the entire amount.

Understanding Net Earnings

Net earnings are calculated by subtracting business expenses from gross income. Gross income refers to the total income earned by a business before any deductions are made. Business expenses are costs incurred in the course of running the business. These can include costs for supplies, advertising, travel, and home office expenses among others.

It's important to note that not all expenses can be deducted from gross income. Only those that are deemed 'necessary and ordinary' for the business can be deducted. Necessary expenses are those that are helpful and appropriate for your business. Ordinary expenses are those that are common and accepted in your trade or business.

Determining Gross Income

Gross income for self-employed individuals can come from various sources. It can be from sales of products or services, rental income, or income from investments related to the business. It's important to keep accurate records of all income sources as they will be needed when calculating net earnings and filing taxes.

Income should be reported in the tax year that it was received. This means that if you performed a service in December but didn't receive payment until January of the following year, the income should be reported in the year it was received.

Identifying Deductible Expenses

As mentioned earlier, not all business expenses can be deducted from gross income. The IRS has specific guidelines on what can and cannot be deducted. Generally, expenses must be both ordinary and necessary to be deductible. Some examples of deductible expenses include costs for advertising, office supplies, rent, utilities, and insurance among others.

It's important to keep accurate records of all business expenses. This includes keeping receipts, invoices, and other documentation that can prove the expense was for business purposes. This will be crucial in case of an audit by the IRS.

Calculating Net Earnings

Once you have determined your gross income and identified your deductible expenses, you can calculate your net earnings. This is done by subtracting your total deductible expenses from your gross income. The result is your net earnings, which is the amount that is subject to self-employment taxes.

It's important to note that if your expenses are greater than your income, you may have a net loss. This can be carried forward to offset income in future years, potentially reducing your tax liability in those years.

Example of Net Earnings Calculation

Let's say you are a freelance graphic designer. In a given year, you earn $80,000 from various projects. Your business expenses for that year, including costs for software, advertising, and home office expenses, total $20,000. Your net earnings would be calculated as follows: $80,000 (gross income) - $20,000 (business expenses) = $60,000 (net earnings).

This means that your self-employment taxes would be calculated based on the $60,000 net earnings, not the $80,000 gross income. This is why understanding and accurately calculating net earnings is so crucial for self-employed individuals.

Understanding Self-Employment Taxes

Self-employment taxes are made up of two parts: Social Security and Medicare. As of 2021, the Social Security tax rate is 12.4% and the Medicare tax rate is 2.9%, making a total self-employment tax rate of 15.3%. However, these rates are applied to 92.35% of your net earnings, not the full 100%.

This is because in a traditional employment setting, the employer would pay half of these taxes. As a self-employed individual, you are considered both the employer and the employee, but you can deduct the 'employer' portion of these taxes, which is why the tax is applied to 92.35% of net earnings.

Calculating Self-Employment Taxes

To calculate your self-employment taxes, you first need to determine 92.35% of your net earnings. You then apply the combined tax rate of 15.3% to this amount. The result is your self-employment tax liability for the year.

For example, if your net earnings for the year are $60,000, you would calculate your self-employment taxes as follows: $60,000 x 92.35% = $55,410. This is the amount that the self-employment tax rate is applied to. So, $55,410 x 15.3% = $8,477.73. This is your self-employment tax liability for the year.

Reporting and Paying Self-Employment Taxes

Self-employment taxes are reported and paid using Schedule SE (Form 1040), which is filed with your federal tax return. This form is used to calculate your self-employment tax liability and to report that amount to the IRS.

Unlike traditional employees who have taxes withheld from their paychecks throughout the year, self-employed individuals are responsible for making estimated tax payments throughout the year. These payments are typically due on a quarterly basis and are based on your estimated net earnings for the year.

Estimated Tax Payments

To calculate your estimated tax payments, you need to estimate your net earnings for the year. You then calculate your estimated self-employment tax liability based on these earnings. This amount is then divided by four to determine each quarterly payment.

It's important to note that if you do not make estimated tax payments or if your payments are not sufficient, you may be subject to penalties by the IRS. Therefore, it's crucial to accurately estimate your net earnings and make your payments on time.

Filing Schedule SE (Form 1040)

Schedule SE (Form 1040) is used to report your self-employment taxes to the IRS. This form includes sections for calculating your net earnings and your self-employment tax liability. It also includes a section for deducting the 'employer' portion of the self-employment taxes.

Once you have completed Schedule SE, the self-employment tax liability is transferred to your Form 1040, where it is added to any other tax liability you may have. This total is then compared to your estimated tax payments and any withholding you may have from other sources to determine if you owe additional taxes or if you are due a refund.

Conclusion

Understanding net earnings and self-employment taxes is crucial for anyone who is self-employed. By accurately calculating your net earnings and understanding your tax obligations, you can ensure that you are paying the correct amount of taxes and avoid any potential penalties from the IRS.

Remember, it's always a good idea to consult with a tax professional if you have any questions or concerns about your taxes. They can provide guidance and help ensure that you are in compliance with all tax laws and regulations.