Perhaps you get a check, or you receive cash for the services you provide your employer or customers. 

If you get a paycheck have you ever looked at your paystub? Do you understand what your paystub tells you? It breaks down gross pay, net pay, withholding, pre-tax and post-tax deductions. You probably get something called a W-2 sometime in January following the new year. Does this ring a bell? 

Perhaps you get paid with cash, are you an independent contractor? That’s someone who works odd hours on call or does special one-off jobs for a business. If so, you probably get something called a 1099-NEC/MISC sometime in January. 

So, what does this have to do with money? Well these two classifications are critical for you to understand because one of these for every $1 you earn; you get to keep less of that dollar due to something called Federal Self-Employment Tax.

Federal self-employment tax is 15.3% so on that first dollar you make, the government gets to keep $0.153. An employee’s dollar is subject to the same tax rate, however their employer matches half of the 15.3% rate (7.65%)  known as FICA/FUTA (1.45%) and Medicare/Social Security ( 6.2%); and the employee pays the other half from their own earnings through deductions on their paystub. Therefore $1 earned as an employee is worth more than $1 earned as an independent contractor. Although this may seem unfair, this sets up the market incentives for independent contractors to offer cheaper labor, because they are baring the “employer” tax burden.

For example when an outside worker approaches a business to work as an independent contractor, they will pitch the business something along the lines of “We can do this job for $30/hr” the business owner will come back and say “We currently pay our help $28/hr sorry you’re not cheaper”. But guess what? The business owner is wrong. The independent contractor is actually cheaper!

Factor in the employer portion of taxes that $28/hr is actually $2.14 higher ($28* 0.0765) their true cost is $30.14/hr along with other taxes such as workman’s comp. Workman’s comp varies in some places but in Iowa it’s about $1.48/per $100 gross wages. If we add that in you’re looking at an additional $0.41. So that employee is actually costing you $30.55/hr. Lets say this independent contractor will take over software/tech design and will run tech support for the company. Well at 2080 hr (52weeks *40hrs) making the switch could save the company (($30.55-30=$0.55)*2080)$1,144 a year!

So that’s great for the business owner, but as stated previously it shifts the tax burden to the contractor. Two thing that lessens this burden for the self-employed individual is they are able to deduct business expenses , along with half of their SE tax paid in. So if they made $100, and paid in $15.30 , they would get to deduct $7.65 and receive a tax benefit of ($7.65 * (their tax rate). Lets use 12% as an example ((7.65*.12)= $0.91.  This still makes the independent contractor on a dollar per dollar basis worse off by $6.74 ($7.65-$0.91) if they would have made that same $100 through an employer as a W-2 employee.

So, for example, if you can make $100,000 as a self-employed individual after expenses on your Sch-C in your line of work and you are offered a salaried job for less money should you take it? Well if you take $100,000/ 1+ (0.0765) (7.65% employer portion). You get a total of $92,894. If you get offered over $93,894 you are better off working for the employer, as all other taxes you are subject to do not change based on whether you are self-employed or an employee. Not only will after tax wages be comparable but you will likely be eligible for some beneficial employer benefit programs such as a 401k (Roth or Traditional), decreased medical insurance costs, and a Health Savings Account (HSA). These benefits can save you money on your tax bill throughout the year.

That really is the only difference between the two classifications tax wise. Both incomes are subject to Federal and State taxes. Federal and most State taxes are figured on a progressive scale. Progressive meaning from incomes of $0-10,000 is taxed at 10%, from 10,001-20,000 is taxed at 12% and so on… So, if you earned $20,000 your tax due is ($10,000*10% +((20,000-10,001) *12%) = (1,000+1,200) = $2,200. So as your income rises, your tax deductions or business expenses are worth more to you, because they offer a greater benefit per dollar spent.

With the above example in mind, I still hear a lot of people talk about a raise pushing them into a higher tax bracket, and their entire incomes being subject to a higher tax. Except as you see above, if you get a raise that pushes you into a higher tax bracket of 12% from the bracket of 10%, all of your income you were earning in the 10% bracket is still taxed at 10%! It’s all the new income you earn that is taxed at 12%. You can find your respective tax bracket by searching “current year federal tax brackets” on Google.

If you need any help regarding these issues, please reach out to Corridor Consulting, we would love to assist you in any issues you may have. If you’d like to schedule a consultation you can do so here.

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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed