What it means to go from “employee” to “contractor”.
In the eyes of the IRS, there are two types of employees for payroll purposes; W2 employees and 1099 contractors (aka consultants, entrepreneurs, business owners, freelancers, and self-employeds). While there are caveats that your employer needs to consider when classifying you as either, the main differences to you are who is responsible for paying the taxes related to your income, and what can be deducted against this income.
As a W-2 employee, your company calculates and withholds federal, state, social security, and medicare taxes from your pay before writing you a check, and then they submit these taxes to the IRS on your behalf. They also split the latter two taxes, often called FICA, 50/50 with you — you pay 7.65%, they pay 7.65%. Other benefits can include pre-tax benefits like health insurance and retirement plans.
On the other side, as a 1099 employee, the onus of paying your taxes falls entirely on you. You (or your tax pro) are responsible for calculating and remitting all taxes to the IRS and state authorities — including the full 15.3% FICA tax (known to 1099s as Self Employment or SE tax). You’re also required to do this quarterly and can be subject to penalties if you don’t pay enough. What’s enough? 90% of the current year’s tax, or 100% of the prior year’s tax. As if that wasn’t enough salt in the wound, you can’t take part in the pre-tax benefits mentioned above for W2 employees.
W-2 — Gets benefits, less work, splits FICA with employer
1099 — No benefits, more responsibility, and more tax
So, why in the world would you ever want to be a 1099 employee?
Deductions, my friends…. deductions.
As a 1099 employee you have access to deductions that W2 employees do not. Uniforms, professional fees, travel, meals, liability insurance premiums, professional dues, subscriptions, and more were all taken away from W2 employees with the Tax Cuts and Jobs Act of 2017. However, as a 1099 contractor, you are able to deduct these and other job related expenses from your income before calculating the self employment tax due. Other things you can deduct from your net income when figuring your federal income tax include SE health insurance premiums, contributions to a SE retirement plan, and (wait for it!) one half of your SE tax.
As a 1099 contractor, you also generally have more freedom when it comes to how, when, where, and who you work with. You can set your own hours, work how you want, and choose which projects you accept or reject. Just remember, with great power comes great responsibility.
What to expect
So what should one expect when making the move from W2 to 1099?
First and foremost, a higher tax bill. The sticker shock from SE tax is real, so be ready to be smacked with that 15.3%.
Second, be ready to track and document your job related expenses. Not sure what you can deduct? Talk to a tax pro about your industry standards. More deductions = less tax.
Third, be prepared for your quarterly estimates. If you’re not paying enough, you will get a .5% penalty for each month that the tax is considered unpaid. If you don’t pay your quarterly estimates, be prepared to write a check come April 15th.
What if I don’t want to deal with this?
There are ways for 1099 contractors to mitigate the SE tax burden, such as forming an S Corporation, but they will subject you to additional tax filing requirements. Have a conversation with a tax pro to determine the best move for you.
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