So, you got a new job. Hurray for you! Your new boss said that you're going to be an independent contractor. What does that mean? If you don't understand your situation and plan ahead, that can mean a very large and unexpected tax bill. Below are just a couple of the common questions that are asked of me with regard to independent contractors and 1099s.
"What is an independent contractor and how is that different from all my previous jobs?"
The first time I was hired as an independent contractor (in a previous life, before I was an accountant) I had relatively no idea what that meant. I knew that I filled out a different form to be hired (a W9 instead of a W-4). I knew that my new boss said that they wouldn't be withholding taxes. Then came tax time, and I cried. The end.
When you're classified as an independent contractor, you're technically self-employed. This means that the company that is paying you is not withholding taxes from your pay, and they also aren't matching your taxes. When you're an employee, you pay half of your taxes from your paycheck (usually around 7.5%), and your employer matches that. When you're self employed, the entire tax burden falls on you and you're also subject to self employment tax. The pain from these facts can be mitigated if you plan ahead, but the tax burden is something that should definitely be considered before taking on contract employment; you should remember that a portion of what you're bringing home isn't yours, it's Uncle Sam's.
"How can I be prepared for tax time if I am an independent contractor?"
If you're working in a position that you know taxes are not being withheld from, you need to plan ahead. The first step is to save a portion of your pay for your eventual tax liability. I recommend consulting with a tax professional about your specific situation, since everyone's taxes are different, but a good rule of thumb that I tell people that are self-employed is to save 30-35% of every check. I highly recommend establishing a separate savings account specifically for those funds so that you aren't tempted to spend that money throughout the year. If you're self-employed, chances are you will end up owing the IRS when you get your taxes done, and it is a lot easier to stomach a large tax liability when you already have the money tucked away to cover it.
I know that 30-35% is a lot of your pay. If you're being paid $10/hour, I'm basically telling you that only $6.50 of that is actually available to you. Other accountants might tell you to save less. Here's how I like to think about it; I would rather have you save too much and have money leftover after you pay your taxes, as opposed to recommending you save too little and then you have to come up with even more money to cover your tax liability. I tend to be conservative with my estimates because I like for my clients to be prepared for the worst case scenario.
"This sounds like it sucks. Is there any benefit to being an independent contractor?"
The tax side of being an independent contractor is kind of harsh, I'll be the first to tell you that. Whenever a client hands me a 1099-Misc with a lot of money in Nonemployee Compensation, I wince a little on their behalf. However, there's a silver lining.
When you're self-employed, you can write off far more on your taxes than you can when you're an employee. You can write off mileage, tools, qualified meals, a portion of your cell phone and even a home office if you have one. When you're self employed, you may also be eligible to deduct half of your health insurance premiums. If you travel, there are per-diem deductions that can be factored as a deduction. Keep your receipts for everything you pay that is at all related to your self-employment; many of those items are deductible.
The Bottom Line
If you're going to be paid as a contractor and you know that taxes aren't being withheld from your taxes, it's in your best interest to start working with an accountant as soon as possible. Once the year ends, there is very little that can be done to affect your tax situation retroactively, but if you are working with a tax professional throughout the year to plan ahead, you're more likely to be in the most beneficial position possible when tax time rolls around. I know that many people prefer to do their own taxes, but if you're considered self-employed in the eyes of the IRS, I recommend working with a professional who will know more about every deduction that you are eligible for and will help to ensure that you don't have to hand over more of your pay than you need to for your taxes.
If you have more questions about self-employment, 1099s or how to plan ahead for your taxes, you can contact me directly via kcanavan@canavanfinancial.com or by calling 303.284.1096.
