Why a $10,000 gig might not yield you so much

Homeless sleeping on the sidewalkIf you are self-employed,* then your income will be subject to two forms of federal taxes (not to mention state and local taxes): federal income tax and self-employment tax.

Federal income tax

Federal income tax is assessed at the rate on your income tax return.  This varies based on your family income. In the US, our tax system is progressive – the more you make, the higher the percentage you are supposed to pay .  Also, single taxpayers usually pay higher rates than married taxpayers with children.  Deductions, such as charitable giving, mortgage interest, and state and local taxes, may lower your tax rate.

You should know your marginal tax rate.  This is the rate of federal income tax on one additional dollar earned.  Ask your accountant or look it up in your tax preparation software.  Use this rate to consider how much income will be left from a particular project after Uncle Sam has finished with you.  For example, if my marginal tax rate were 33%, then a new $10,000 consulting project will only yield $6,700 in take-home (10,000 – [33% x 10,000]).

Self-employment tax

Self employment tax in 2011 is 13.3% (10.4% for Social Security and 2.9% for Medicare).  The first $106,800 is taxed at the full 13.3%, .  Any additional income is only hit with Medicare Tax, 2.9%.  Taxpayers who have already paid social security with their wages may be exempted from some, or all of their Social Security tax).

Let’s return to my $10,000 consulting project.  Suppose I haven’t paid any social security this year.  Then I will also need to pay an additional $1,330 ($10,000 x 13.3%) in self-employment tax.  My net yield will be $5,370 ($6,700 – 1,330) after federal taxes.**

Any state income tax will further reduce your yield.***

When you take whatever money is left and spend it, you will probably be paying sales tax on whatever you buy.

Learning income tax rules and careful planning can reduce these taxes.

For one thing, carefully document your expenses and take all of the deductions that you can.

You also may be able to time your income and expenses so that you pay taxes on it later, rather than sooner.  For example, if you receive a check on December 31, it gets taxed this year.  A check received on January 2 of next year gets taxed next year. On the other hand, an expense incurred this year can be deducted now.  An expense after December 31 can’t be deducted until next year.

The moral of the story: knowing your tax situation and basic tax rules can save you a lot of money.

*I wrote this post about a self-employed individual, rather than a corporation.  If you choose to incorporate, you will be subject to corporate taxes and also individual taxes on dividends, not to mention income taxes on salaries you take from the corporation.  Incorporating may reduce or increase your taxes, depending on the situation.

**This kind of motivates me to stop working and spend more time with my family.

***A good reason to leave New Jersey and move to Texas or Florida.

[Image: Homeless sleeping on the sidewalk by Franco Folini, on Flickr]