If you’re self-employed, you obtain Social Security and Medicare coverage through the payment of self-employment tax, computed on Schedule SE. The Social Security Administration uses the information provided on Schedule SE to determine your benefits under the Social Security program. If your self-employment income is $400 or more, you must file Schedule SE and pay self-employment tax, regardless of your age, even if you’re receiving Social Security benefits.
The 15.3% self-employment tax rate is composed of the 12.4% Social Security tax and the 2.9% Medicare tax. For 2007, the maximum amount subject to Social Security tax is $97,500. However, all self-employment income in excess of $400 is subject to Medicare tax. Before calculating self-employment income, you deduct 7.65% from your net earnings, which means that only 92.35% of your net self-employment income is subject to self-employment tax.
You can deduct one-half of your self-employment tax as an adjustment to income on Form 1040, which decreases your federal income tax. For example, if one-half of your self-employment tax is $1,000 and you are in the 25% tax bracket, this saves you $250 in federal income taxes.
Example: Your only income in 2007 is $32,000 in self-employment income, and you have no adjustments other than the deduction for one-half of your self-employment tax. Your self-employment tax is $4,521:
$32,000 (Self-employment income) X 92.35% (Amount of income taxed) X 15.3% (Tax rate) = $4,521
Your total adjustment to income is $2,261, which is one-half of your self-employment tax ($4,251). And your adjusted gross income is $29,739:
$32,000 (Self-employment income) - $2,261 (Self-employment tax deduction) = $29,739