Self-Employed Taxpayers Get a Break

The Small Business Jobs Act of 2010, signed into law by President Obama on Monday, provides a new temporary tax break for self-employed taxpayers.

To understand the tax break, you first have to understand the tax. Currently, salaried employees who receive a W-2 pay FICA tax on their wages and their employer pays an equal amount of FICA tax.

Meanwhile, self-employed taxpayers pay a “self-employment tax” on net earnings from self-employment that represents both the employee and employer share of the FICA tax. An employee pays 7.65% of his/her wages in FICA tax, while a self-employed individual pays 15.3% in self-employment tax.

Currently, a self-employed individual can deduct 100% of the cost of health insurance premiums, including long-term care insurance premiums up to the dollar maximum allowed based on the taxpayer’s age. Because the deduction is claimed as an adjustment on Page 1 and not on Schedule C it reduces federal income tax but not the self-employment tax.

Here's where the tax break comes in. For tax year 2010 only, self-employed taxpayers can deduct these insurance premiums when calculating self-employment tax

The self-employment tax is calculated by multiplying 92.35% of the net earnings from self-employment by 15.3%. So if the net earnings from self-employment, determined on Schedule C, are $1,000, the self-employment tax is $141.30. A half of the self-employment tax can be deducted as an above-the-line adjustment to income, thus reducing the effective tax cost.

The actual effective self-employment tax rate depends on your federal income tax rate. Taking into account the 50% self-employment tax adjustment to income, the “effective” cost of the self-employment tax is:

  • 15% Bracket = 13.07%
  • 25% Bracket = 12.36%
  • 28% Bracket = 12.15%