How self-employment affects Social Security benefits

Over 16 million U.S. workers count themselves as self-employed in 2019, according to the Pew Research Center. Even more claim some type of self-employment income on their taxes. In fact, over 25.5 million taxpayers reported self-employment income in 2016 alone, and each was responsible for paying self-employed Social Security tax on those earnings.

With self-employment on the rise, many entering the ranks wonder how Social Security tax for self-employed workers actually works, and how it impacts retirement benefits and planning.

“Self-employed workers pay self-employment tax on their reported net income — basically the profits — from self-employment activities,” says Tammy Mihail of Tamara L. Mihail CPA, LLC, a firm specializing in small and mid-size business taxes and accounting. 

“Self-employment income can include many things,” says Mihail. “Contract work reported on 1099s, income from business activities under a sole proprietorship, partnership income filed under a K-1, and even income from farming reported on Schedule F can be considered self-employment income, and therefore subject to the self-employment tax.”

“The self-employment tax is simply the combined Social Security and Medicare contributions that you make based on your self-employed income,” adds Mihail. “Self-employed workers must pay the entire amount, currently 12.4% for Social Security and 2.9% for Medicare.” 

In contrast, employees who earn a paycheck only pay half of these amounts — 6.2% for Social Security and 1.45% for Medicare. Their employer covers the rest on their behalf as part of their payroll taxes. 

To minimize their self-employed Social Security and Medicare tax burden, most small business owners and self-employed workers subtract business-related expenses from their earnings. This lowers reported profits and, in turn, reduces what they pay in Medicare and Social Security tax for self-employed income. 

Self-employed freelance writers, consultants and service providers might have just a few expenses to deduct. However, self-employed plumbers, electricians, mechanics and contractors can have many expenses that lead to low profits, and even losses, over many years. 

Low profits mean you’ll pay less in self-employed Social Security and Medicare taxes. However, Mihail warns, “if you don’t pay much in self-employment tax because of low profits, you’re not building up your Social Security ‘bank’ for retirement.”

Ultimately, if self-employment makes up the majority of your career and you’ve reported minimal profits or even losses during that time, you may not have much Social Security coming your way when it’s time to retire. 

Even if you make generous contributions to Social Security over time, those benefits alone are unlikely to cover all of your retirement expenses. That’s why many self-employed workers tap a wide variety of retirement savings alternatives. 

Look to traditional tax-deferred retirement savings

Self-employed workers can contribute to a variety of tax-deferred savings accounts to supplement their Social Security benefits. Some, like SEP IRAs and Solo 401-Ks, and are geared specifically for business owners and self-employed workers. Others, like Regular and Roth IRAs, are open to both employed and self-employed workers.

The secret to this strategy, say many self-employed workers, is setting up regular deposits.

Jared Bauman, self-employed founder and CEO of 201 Creative says, “a SEP IRA is similar to a 401k, but designed with small business owners in mind. I schedule a monthly withdrawal instead of waiting until the end of the year to do a lump-sum contribution. This keeps me on track and makes it a part of my budget.”

Britta Schell, the self-employed founder of Britta Schell Consulting, makes retirement contributions a priority, too. “My financial advisor introduced me to the Solo 401K,” says Schell. “It works just like a 401K, but I am both the participant and administrator. I try to make contributions as early in the year as possible from my first paid invoices.”

Anticipate medical needs in retirement planning

Part of your self-employment tax covers Medicare contributions and, like the self-employed Social Security portion, these contributions are based on your net profits. Though, even with healthy contributions, Medicare is unlikely to cover your retirement needs. Luckily,  self-employed workers can pre-plan for medical expenses with health savings accounts (HSAs).

“As a Medicare expert, I know first-hand how important it is to enter retirement with a pool of money designated for healthcare expenses,” says co-founder of Boomer Benefits, Danielle Kunkle. “An HSA allows me to create and grow an account that I will be able to use in retirement for Medicare deductibles, copays and coinsurance, as well as long-term care costs and dental, vision and hearing expenses that Medicare does not cover.”

“I love the HSA feature that allows me tax-free withdrawals for medical needs,” adds Kunkle. “Plus,  when I turn 65, I can withdraw money for non-medical expenses with no penalty, only paying regular income tax.”

Calloway Cook, the self-employed founder of Illuminate Labs, Inc. agrees, saying “many entrepreneurs are on high-deductible healthcare plans to save money, and this type of plan makes you eligible for an HSA. You can invest in equities in an HSA, plus your contributions are pre-tax. So, you get the benefits of growing a nest-egg for retirement health needs while minimizing your tax burden.”

Make exit strategies part of retirement planning

Many small business owners view the business itself as their retirement fund. When the reputation management firm Womply surveyed over 3,000 U.S. business owners, they found that “overall, 41% of business owners plan to sell their businesses at retirement.”

“However, our survey also shows that 84% of business owners age 45 or older plan to sell,” says Womply’s senior marketing director, Dallin Hatch. “In many cases, poor financial planning and unfortunate economic events have left many Boomer-age self-employed business owners unprepared for retirement and looking for a nest egg, hence the desire to sell.”

Selling out isn’t just a last-ditch effort to cover retirement expenses. For many, it’s part of a planned exit and retirement strategy. 

“Of course, the hope is that the sale of this business will provide me a comfortable retirement,” says Boomer Benefits’ Kunkle. “But nothing is ever for certain, so I invest and save as if selling out were not a given.”

Consider real estate investments and other income streams

The self-employed are a creative and resourceful bunch, and thus, retirement does not mean sitting on their laurels. Real estate investments and ongoing income opportunities rank high on the list of ways to supplement self-employed Social Security benefits.

“Owned real estate is an ideal way for small business owners to fund their retirement,” says Charles Read of Get Payroll. “I own my own income-generating building and have helped clients set up similar programs that use real estate investments, usually in their business’s facilities, as substantial income-generating or salable assets for retirement.”

Bauman also relies on real estate for retirement income. “Owning property will be my pension,” he says. “Whenever we have a good year in business, we set aside money for a down payment on a property. We currently own several duplexes and apartment complexes, and we have the mortgages set to pay off before we hit retirement.”

Real estate is just one type of retirement income stream that can supplement self-employed Social Security benefits. In fact, building additional retirement income is what drives many full-time workers to enter the ranks of the self-employed in the first place. 

“Something I learned from others who retired early was that you need multiple streams of revenue,” says Jeff Neal, owner of The Critter Depot, an online store that sells feeder crickets and roaches to reptile owners. “My full-time job provides enough for my family’s expenses and incremental savings, but I would never hit early retirement without additional income.”

“So I started selling crickets online,” says Neal. “I net about $2,000 per month, which all contributes to my savings.”

Neal is just one of the millions of workers who supplement full-time pay with self-employment income. Self-employment taxes apply to part-time and side-gig income as well, further building your Social Security and Medicare benefits “bank,” while bolstering your overall retirement bottom line.