Ever wondered what the differences between a W2 and a 1099 contractor is? Ever thought about going 1099 but were scared because of taxes? Well, today I’m going to demystify the whole process to help you understand what might be the right path for you.
I’m not a CPA or an attorney. This is not legal advice. This is my opinion and comes with no warranty. If anything I say is wrong and you listen to me and you get in trouble with the IRS; that’s on you. I highly recommend working with a CPA or an attorney. A few services come to mind to find a CPA: TaxFyle, HR & Block or even Google can help you find the right advisor for you.
Defining Employment Options
Now that I got the legalese out of the way, lets get to it.
When we talk about employment in the USA, there is really 4 different ways:
- Single member LLC – Basically “Self Employed”. Could be an online business, consulting or a variety of different services / products. This is where you could get a 1099 from a client, or you might have receipts from products you’ve sold.
- W2 contractor – Basically you’re an employee of a contracting firm, think of a company like Robert Half Technology, kForce, TekSystems or Apex Systems. These are big firms that are hired to bring staff onto specific projects and teams, typically for a big client (Such as one from the Fortune 500). The client pays the middle man, the middle man takes taxes out and cuts you your share of the money. Benefits tend to be non existent or expensive. PTO typically isn’t provided and most of the time you work for an hourly bill rate.
- Sole Proprietor – basically operates the same as a Single Member LLC, except you don’t get any corporate protections. Can receive a 1099 or estimate based off of receipts.
- Employee. You get a W2 at the end of the year; typically the position comes with PTO, benefits and other nice things. The pay tends to be lower then a 1099 contractor or a W2 contractor but it typically is more stable then a contract role
What is the difference between 1099 and W2?
Basically 1099 from the IRS perspective means you’re self employed. You get a client, they pay you $x in a year but they do not do any tax withholdings. A W2 on the other hand has a lot of different overheads:
- The employer is responsible for taking taxes out
- The employer has a legal share of social security and medicare taxes
- The employer is typically required to carry many forms of insurance: unemployment, health insurance, errors and omissions and finally liability insurance
Show me the money
I’m going to give you a couple of different case studies to consider when you’re weighing your options between W2 or 1099 contracting.
Let’s say you’re named Bob. You are offered $100 an hour on a 1099 to work for a big tech company. They also offered you $85 an hour to work as a W2 contractor. You do quick math and figure the 1099 route will pay $200,000 if you work 2,000 hours or the $85 rate will pay you $170,000. Which one should you chose?
Case Study Assumptions
- You live in Colorado or have to pay state income taxes (AKA you don’t live in Wyoming)
- You’re not married, filing single (Which I’m not, but it doesn’t make it THAT much more complicated)
- You don’t have a mortgage or anything like that to complicate things (investments, rentals, properties, etc..)
The reason for the above is to show you how straight forward and clear cut the decision is. If you have children, married, have properties your taxes are more complicated, but at the same time those things will LIKELY cause you to pay less in taxes in either situation: W2 or 1099.
We reference the Tax Foundation for income tax tables.
At the end of the year you will gross $170,000.
- You will pay 7.65% on social security and medicare: ($13,005)
- You will pay state income tax. ($7820)
- Since you’re in the single bracket, so the tax rate is 32% for your income, remember it’s a progressive tax; thus your effective tax rate is 18.8% ($31,905)
After all taxes, you will NET: $117,270. Not bad. But is this the best option? $117k will do a LOT for you, this is $58.50 an hour after taxes, but what about the 1099 option?
At the end of the year you will gross $200,000. See the IRS for 12.4% and 2.9% info.
Lets talk state and social security taxes first.
- You will pay 12.4% (Self employment tax) on social security for the first $128,000. ($15,872)
- You will pay 2.9% for medicare on ALL income. ($5800)
- You will pay state income tax. ($9200)
Typically for the above, you will have to file a quarterly report with the IRS and some states also require it for their tax system. Remember talk to a CPA. Part of quarterlies is to pay 25% of the sum of 1 and 2 based on actuals: $5168 per quarter.
You’re in the same tax bracket as the W2 role thus you’re looking at a tax bill of about $31,905. This is calculated however before social taxes are taken out and any deductions.
Total burden: $62,777, total net income of: $137,223; or about $68.62 an hour.
Deductions are key to saving on income taxes
Here’s a brief list of things you can deduct from your taxes:
- Home office credit. Work from home? You can deduct upto $600 a year off your taxes
- Internet costs
- Rent or mortgage expenses (eg, you rent an office or you have a house dedicated in your room for your work)
- Health Insurance
- Cell Phone usage (Anything over 50% of the bill puts you at a higher risk of audit, best bet for that and internet to claim 40% of the cost)
- Business insurance
- Furniture and office supplies
- New equipment
- Business Travel Expenses
- Travel / To and From client site if it’s not part of a regular commute; EG need to drive 100 miles to meet the client to demo the project
- Food / beverage: You can take your client out to lunch; but you can only write off 50% of the tab.
- Self Employed Pension Individual Retirement Plan. Basically a self funded pension; works like a 401k. Basically you can sock away $57,000 before (Traditional) or after taxes (Roth)
Given the above, lets figure out our deductions:
- $0; we use a co-working space
- Rent a co-working space for $300 a month; $3600 / year
- $400 a month; yay! $4800 / year
- $20 a month! $240 / year
- Pens, markers and a hermin miller chair: $700 / year
- Brand new Macbook baby; lets get an iPad too. $2700 / year
- N/A, covid 19 man
- N/A, covid 19 woman
- $25,000 in a traditional account; we were not feeling optimistic about the future.
That means we can deduct the total: $37,640. That means we can take the Gross amount less our deductions less the standard deduction of $12,400 to get an Adjusted Gross Income of $149,960. Which means that the tax burden would be $30,070; about 18.5% effective tax rate. Thus your take home would be $132,290.
Given the fact the company offered an extra $15 above W2 allowed us to basically earn $15,000 more a year is great. This is a good deal.
But wait, there’s more
Channeling my oxy clean commercial watching days; but wait there is more! Love him or hate him, Trump’s tax cuts did really help the self employed like us. There’s a new law on the books, it’s called the 199A. Basically, if you qualify, you can take 20% of your gross earnings, plus the standard deduction plus your above expenses to get a new Adjusted Gross Income of:
$40,000 + $12,400 + $37,640 = $90,400 able to deduct. $200,000 - $90,400 = $109,600 of AGI
Given that in this situation we are at an AGI of $109,600. Our effective tax burden is $17,417; a mere 15.9% tax rate….
Combining everything together:
- Our income tax is $17,417
- Our Social Security and Medicare burden is $31,905
- Our total take home income is: $150,678; or about $75 an hour AFTER taxes
What if the W2 offered the same rate? Let’s figure that out!
$100/h2 W2 rate, 200k annual gross income:
- Social Security and Medicare burden is $15,300
- State income tax of: $9200
- Federal Income tax: $41,413 (Standard deduction, no extras)
$15,300 + $9200 + 41,413 = $65,913 tax burden, thus net income of $134,087. An after hourly rate of $67.04.
It’s great, really good money.
What’s the best outcome?
Lets look at the HOURLY rate after taxes because it paints the most clear picture.
- 1099 without the 199A: $68.61 an hour (after taxes)
- 1099 with the 199A: $75 an hour (after taxes)
- W2 at the same rate as 1099: $67.04 an hour (after taxes)
If the 199A were to go away, would the 1099 option be worth it over a W2 option? It depends, yes its a little bit more over head to gain an extra $2000 with some very basic deductions. The advantage though is that as your situation changes so does the tax ADVANTAGE. If you get married, buy a house or increase your SEP-IRA contributions you will see a wider increase of hourly net pay. This is helpful because it gives you the ability to control your tax burden.
Also, social security is capped at $128,000 of earned income, which in the beginning of the year results in a smaller check, but towards the end of the year your check gets a bit bigger. Maybe $300-500 more a month.
Some cons that could factor into a 1099 would be if the client requires:
- Errors and omissions insurance; this can be expensive, typically you’d increase your rate to offset the expense but might not always be feasible.
- Unemployment insurance. Technically you don’t have to carry it, but if the client required it for some reason, it would increase the costs (And possible deduction!) of taking on that client
What does Adam do?
I have a Sole Member LLC. Why? Insurance, limited protection and taxes. I get a 1099 at the end of the year and if I grow, I can hire employees which is harder to do with a sole proprietor.
Other reasons I chose the 1099 route:
- 199A. This thing is magical; it will save me a lot of money this year
- Deduct a ton of different tings; my health insurance premiums for one thing
- More control
- I can deduct my health insurance which works out to be almost $5000 a year
I avoid clients that require errors and omissions insurance or I at-least am a sub contractor covered by someone else’s insurance. I don’t carry unemployment insurance because I’m always adding to my savings on every paycheck.
I think with or without the 199A tax law, being a 1099 contractor is the best employment option. You are in the drivers seat, you are a vendor. For me, it’s part of my mindset, for many others it could be quite scary not to have employer provided benefits. For example, I was working with MBO for a while and my account manager said that she’d be terrified to have to carry hear own health insurance without her employer! Personally with the market place and the Affordable Care Act that American insurance is getting better, but what do I know? :)