The Thing We Never Talk About

Timothy Iseler: Hi everyone.

Welcome to The Thing We Never
Talk About, a podcast about

personal finance for weirdos.

My name is Tim Iseler.

I'm a certified financial planner,
and I run my own independent financial

advisory business in Durham, nc
helping artists, musicians, and

other people with weird jobs take
control of their financial lives.

You can learn more about that
business at iselerfinancial.com.

And one more note before we dive
in today, I'd like to do a listener

mailbag episode in the future.

So if you would like to have your
question answered in a future

podcast episode, please head over
to iselerfinancial.com/podcast.

The annual income tax filing deadline
was just about a month ago now, and

I know that lots of people are happy
to leave that in the taillights

for the next eight to 10 months.

But if you like the idea of dialing
down the stress around tax filing

time, right now is actually the
best time to start thinking about

and planning for next year's taxes.

Today I wanna share some thoughts
on a type of tax that self-employed

people have to pay called cleverly
enough Self-Employment Tax.

Let's start by just clarifying what
Self-Employment Tax actually is.

When we talk about tax planning,
most of the time we mean income

tax, the stuff covered when you file
your 10 40 with the IRS each year.

But there's another type of tax that
applies to all earned income which

we can broadly call employment tax.

While income tax pays for all kinds
of government spending, employment

tax pays into exactly two programs,
social Security and Medicare.

When you have an air quotes,
regular W2 job, your employment

tax is called FICA, and it's taken
out before you get your paycheck.

If you're self-employed though,
whether you're a sole proprietor,

partner in a partnership, LLC owner,
freelancer, or pretty much anybody who

receives a 10 99, that tax is called
Self-Employment Tax, and it gets paid

after you receive your money, typically
using quarterly estimated tax payments.

If you use a CPA or software like
TurboTax or TaxSlayer to file your

annual tax return, chances are that
quarterly estimated payment forms

for this year were automatically
generated as part of last year's filing.

It is important to note that employment
tax is always split evenly between

employer and employee, but when you
work for yourself, you fill both of

those roles, which means you're stuck
paying for both sides of the equation.

The upside is that the employer half
counts as a deduction for income

tax purposes, and the downside
is that you still have to pay it.

I wanna restate a few of those
points just to avoid confusion.

Self-Employment Tax is not an
extra tax that specifically

targets self-employed people.

Instead, it's a replacement for FICA
that W2 workers have automatically

deducted from every paycheck.

Okay?

So it's functionally
the same thing as FICA.

But because self-employed people
are both employer and employee,

they're stuck paying the whole thing.

The actual calculation for Self-Employment
Tax is kind of complicated, but

it works out to about 14.13%

of net business profit.

For contrast, fICA is 15.3%

of earned income.

So Self-Employment Tax actually works
out to be slightly less than FICA.

But again, when you are your own
boss, you're stuck paying both halves.

Are you with me so far?

So when you have a W2 job, your
employer takes a slice of business

income and uses that slice to pay you.

That means that some of the business
profits gets treated as compensation,

and FICA is owed on all of that
compensation, and the rest of the

business profits are not treated
as compensation for tax purposes.

But when you're self-employed,
all of your business profits

are treated as compensation.

That means that Self-Employment Tax
is owed on all net profits, regardless

of whether you internally in your own
bookkeeping, treat that as compensation

or use that money to pay yourself.

I wanna underscore this because it's
a point that's often misunderstood.

If you are self-employed and have
business profits, the whole thing

is treated as earned income for tax
purposes, even if that money sits in

a separate business bank account and
never hits your personal bank account.

Does that make sense?

The IRS does not let you treat only
part of your profits as compensation,

if you are a sole proprietor, partner at
a partnership LLC member or freelancer.

So here's a simple example.

Let's say you're a freelancer and you
earn about 80 K in gross 10 99 income.

And let's say that you spend around
30,000 per year on business expenses

like office supplies, rent, software,
equipment, et cetera, et cetera.

That means your net business profit is
therefore 50 K, 80 K minus 30 K equals 50

k, and Self-Employment Tax is calculated
based on that number, not the gross

number, but that net profit number.

And again, that's true even if the money
stays in a business account and never gets

transferred to a personal bank account.

A couple of notes.

The amount you pay in employment tax
does not reduce the amount you have

to declare for income tax purposes.

That's true for W2 employees and
also for self-employed people.

Okay, so paying employment tax
does not reduce your taxable income

for your annual filing purposes.

Also, even though contributing to
accounts like IRAs 4 0 1 Ks or SEP IRAs

can reduce the taxable income on your
annual 10 40 filing, it does not reduce

the amount you owe in employment taxes.

Again, that's true whether
you get a W2 or a 10 99.

, Okay, since Self-Employment Tax is
calculated on net self-employed profit,

the only way to control how much tax
you pay is to control your profits.

Higher expenses means lower net
income, and lower net income

means less Self-Employment Tax.

That makes sense, right?

. I know lots of self-employed people
who bend over backwards to find things

to write off to reduce their taxable
income, and there is absolutely nothing

wrong with taking advantage of tax code
rules to minimize the taxes you pay.

That's how our system works in
the US and you're entitled to

take advantage of those rules.

But there can be downsides to, let's
call it very aggressive deductions.

One downside is that in the enthusiasm
to find more deductible expenses,

some self-employed people actually
end up spending a lot more than

planned so that they can lump those
purchases in as business expenses.

Like, "I made a lot of extra money
this year, so I better buy a bunch

of stuff so I can write it off."

While it's true that spending an extra
5K in business purchases will reduce

your taxable income by 5K, that's true.

It's also true that you
no longer have that money.

So you save on taxes, but often
you may end up with less money in

your pocket at the end of the year.

I don't necessarily see that as a win.

Sometimes I think that keeping more of
your money for yourself and accepting

the tax impact is a better trade.

But that's just me and
how I see the world.

I would rather keep more of my money,
even if it means paying some taxes.

The other downside of self-employed
people writing off a ton of expenses

to reduce taxable income is that you're
also reducing your access to what

Self-Employment Tax actually pays for:
Namely Social Security and Medicare.

. So while everybody likes paying less
in taxes, please keep in mind that

reducing your Self-Employment Tax also
reduces the benefits you will receive

from Social Security and Medicare.

And unfortunately, lots of self-employed
people just don't have a great plan

when it comes to saving for retirement.

So those benefits will actually
end up being super important to

a lot of self-employed people.

If you're really aggressive in finding
business expenses to write off, you

may pay less in current year taxes, but
you'll also be shortchanging yourself

in retirement in the form of lower
Social security retirement benefits

or higher health insurance costs.

Okay.

Tons of details in there on kind of a dry
topic, but here are the key takeaways:

self-Employment Tax serves the
exact same purpose as FICA.

It's not an extra tax
on self-employed people.

Instead, it's a replacement for the tax
that traditionally- employed People pay.

When you're self-employed,
you pay both the employer and

employee halves of employment tax.

The employer half counts as a
deduction for income tax purposes,

but you still have to pay it.

If you're sole proprietor, partner in a
partnership, LLC member, or freelancer,

the only way to reduce Self-Employment
Tax is to reduce net profits.

And finally, while everyone loves
saving on the ol' income tax bill,

sometimes writing off a bunch of
expenses means less money in your

pocket now and less access to Social
security and Medicare benefits later.

All right.

There is one additional way that
self-employed people can reduce employment

tax, which is more complicated, but
allows you to designate a portion of

your business profits as compensation
and avoid employment tax on the rest.

That's right, i'm talking
about the S corp election.

I'll discuss the difference between
LLCs and S Corps in two weeks, which

is an important but often confusing
topic for self-employed people.

And next week I'll be back with
a conversation with musician,

author and teacher Franz Nikolay.

I read his new book called Band People
subtitle, life and Work in Popular Music,

and found a ton of crossover between
the topics he covered in the book and

the stuff I think about all the time.

Okay, that's it for today.

Now it's time for some disclosures.

The thing we never talk
about is for educational and

entertainment purposes only.

It's not legal, investment or tax advice.

People on the show, including yours,
truly may have interests for or

against any investments discussed.

So do yourself a favor and don't
make any decisions based on what you

hear on this or any other podcast.

If you have a money or finance question
you'd like answered in a future episode,

please visit iselerfinancial.com/podcast.

Again, that's iselerfinancial.com/podcast,

and Iseler is spelled I-S-E-L-E-R.

And if you like what you hear,
please like and subscribe to the

show wherever you get your podcasts.

And you can get my insights on money and
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at iselerfinancial.com/newsletter.

Thanks for listening.

I appreciate you.