What is your 'true' tax rate?

W-2 employees don't pay self-employment taxes. Or do they?

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As an employee, 6.2% of every dollar earned is withheld for Social Security, and an additional 1.45% is withheld for Medicare.

The employer pays the same amount, so that the total amount of Social Security and Medicare taxes withheld is:

= (6.2% + 1.45%) + (6.2% + 1.45%)

= 15.3%

Therefore, on $100,000 of W-2 wages paid by an employer to an employee, $15,300 is paid to the IRS in the form of payroll taxes.

[$100,000 x 15.3% = $15,300].

When this individual goes to file his or her tax return, there will be income taxes due in the neighborhood of 25% (actual rate depends on filing status).

Therefore, the total tax paid in this situation on $100,000 of income is:

= ($100,000 x 15.3%)+ ($100,000 x 25%)

= ($15,300) + ($25,000)

= $40,300

This individual's effective tax rate per the tax return will be 25%, but the 'true' tax rate will be 32.65%.

This is because the employee paid half of the payroll taxes:

=25% + (15.3%/2) = 32.65%

So what does any of this have to do with self-employment taxes?

Self-employment taxes are imposed on self-employment income, and the tax rate is 15.3%. This amount represents the employee's and employer's share of Social Security and Medicare taxes, which as mentioned above is = (6.2% + 1.45%) + (6.2% + 1.45%) = 15.3%

So as you can see, payroll taxes and self-employment taxes are two sides of the same coin.

For a self-employed individual making $100,000, the tax due will be the marginal tax rate (roughly 25% depending on filing status) PLUS the self-employment tax rate of 15.3%.

[$100,000 x (15.3% + 25%)] = $40,300

That is, a self-employed individual is stuck paying both the employee's and employer's portion of payroll taxes!

One of the benefits of being employed, therefore, is that the employer covers half of the payroll tax.

This does not mean, however, that a self-employed individual cannot benefit from payroll. (In absolute terms, this means a self-employed individual can still benefit from payroll).

How can this happen, you ask?

Stay tuned for next week's MCMICHAEL CPA TAX BLOG!

Best,

Grant

*You can always email me with questions about taxes at gmcmichael@cpa.com