The SuperDuperMegaGuide to employee vs. independent consulting

I talk to engineers all the time who are interested in being contractors or consultants but are concerned about being “independent” – they still want the perceived safety of being an employee. I’m constantly answering people about “What’s the difference between a W-2 and a 1099,” and so this post lays out the details. (To be clear, this is the difference to the consultant, not the employer. Employers are subject to all kinds of rules about employing you or not.)

Quick Version

If you’re a US citizen or green card holder and you don’t require a group health plan, there’s no functional difference between being an employee or an independent contractor. There’s a financial difference, explained below, that you need to factor into your personal budget, but there’s nothing financially “safer” or “better” about being an employee.

Definitions

An employee is someone who is (duh) employed by a company: that company puts the employee on payroll, pays federal and state employer taxes for the privilege of employing that person, withholds taxes on the employee’s behalf, and sometimes provides benefits to the employee. Your paycheck is always smaller than the actual rate you’re being paid based on withheld employee taxes, federal income taxes, and other withholding: e.g. if you work 200 hours at $100/hr, your paycheck will be <$20,000.

An independent contractor is someone who works for him/herself, and is paid by a company for performing a service. That company does not pay employer taxes and does not withhold employee taxes. Your paycheck matches exactly your rate x # of hours: 200 hrs x $100/hr = $20,000 paycheck. (I’m assuming hourly here, but monthly/weekly pay would be the same.)

You’ll often hear employees called “W-2s” and independent consultants called “1099s” – this is shorthand and refers to the end-of-year IRS tax form that the employer/agency needs to provide the employee/contractor. (There are different rules for international contractors.)

Finances

The primary question for people making a choice is “what’s the difference in my pocket.”

Independent contractors carry a set of financial burdens, plus have some financial opportunities. Let’s walk through them so you can understand your negotiation points. The primary piece to understand is the costs and benefits for being an independent contractor.

1099 Federal Taxes

When you’re an employee of a company, the company pays employer taxes and you pay employee taxes; as an independent contractor, you pay both the employer and employee taxes.

Here’s how these numbers break down for 2012 (these numbers change every year, and there’s some conversation now about reducing the social security taxes):

Federal Tax Type What you pay as an employee What you pay as a contractor
Social Security Tax (Employer) 0 6.2% of your income, up to $110,100 of earnings
Social Security Tax (Employee) 4.2% of your income, up to $110,100 of earnings 4.2% of your income, up to $110,100 of earnings
Medicare Tax (Employer) 0 1.45%
Medicare Tax (Employee) 1.45% 1.45%

Here’s what this looks like in practice:

If you make… Employee tax burden Contractor tax burden Increased contractor cost Increased cost as % of income
$50,000 $2,825 $6,650 $3,825 7.65%
$100,000 $5,650 $13,300 $7,650 7.65%
$150,000 $6,799 $15,800 $9,001 6.00%
$200,000 $7,524 $17,250 $9,726 4.86%

You can see that as your income increases, the relative difference between being an employee and a contractor lessens.

1099 State/County/City Taxes

This is something you’ll need to look up in your area: you may have a B&O (Business & Occupation) Tax for being in the service industry (currently 1.8% in the state of Washington and 0.45% in the city of Seattle), a real estate tax for the privilege of using your own office, etc. In my experience, if this adds up to >2.5%, that would be very high.

1099 Health Insurance

Health insurance as an independent contractor is likely more expensive than as an employee. While it’s likely that an employer will bake in the costs of health insurance when calculating your rate, the cost of insuring you and/or your family in an employer’s plan is almost certainly less expensive than buying your own plan on the open market. If you left a job in the last 18 months, you may still be eligible for coverage under your previous employer’s health insurance in a program known as COBRA. Plan $200-$1000/month more to start.

Unbiased, readable information about individual health plans is difficult to find: NAHU is unbiased but challenging to parse, insure.com provides more optimistic information.

1099 Financial Benefits

So far I’ve only covered the costs side. Here’s the positive side of the equation.

First, all that stuff above – that’s all tax-deductible, meaning that when you calculate your income at the end of the year for tax purposes, you can remove all of those costs. That has some value to you now.

Second, all of a sudden, things that you might buy for business (computers, books) or spend on business (mileage, meals) now become deductible from your federal taxes. Bankrate gives a solid breakdown of areas you might be able to deduct.

Generally this comes to a single-digit percentage of your income during the year – say 3-8% depending on how much you do. So that generally reduces your taxes by 1-3%.

Wrapping Up The Math!

OK, so what’s the incremental cost to be a 1099? Let’s walk through an example, assuming somebody offers you $50/hr as an independent contractor.

Costs Description
$50/hr Starting 1099 hourly rate
-$3.10 SSN Employer Tax
-$0.72 Medicare Employer Tax
-$1.07 State/City tax (assuming Seattle, WA – a bit high)
-$3.00 Health Insurance (assuming it costs $500 more/month)
+$1.00 Post-tax value of expense deductions
+$1.94 Post-tax value of tax & insurance deductions (assuming 25% marginal tax rate)
$45.05 W-2 Equivalent

So there you go. It’s about 11% more expensive to be a 1099 than to be a W-2 – assume some margin of error, and as the hourly rate increases, the percentage difference decreases, as you hit taxable income caps and amortize the costs of health insurance. If you’ve been making $50/hr as a W-2, ask for $55 as a 1099: $100/hr as a W-2, ask for $108. (Well, ask whatever you want.)

Q&A

What if I’m not a US citizen or green card holder?

You can’t be a 1099: you have to be authorized to work in the US to work as an independent consultant. You might be able to find a company that might help for a fee – i.e. a company that might hold your H1-B and bill you out to the hiring company for ~25% of the cost (including those taxes above). If you do, research that company very carefully – that’s a subject for its own post.

You say it’s about 14% more expensive, but my accountant told me to hold on to 25% of my income. Why?

14% more expensive doesn’t mean that you’re paying 14% total in taxes. As an employee, there are taxes being taken out of your paycheck that you aren’t thinking about, but appear when you’re doing your 1040: your accountant is helping you cover both the regular taxes and the 1099 add-ons.

Don’t I have less security as an independent contractor?

No. (This is the opinion part of this post, to be sure.) There’s no fundamental difference from the employer’s perspective – there’s just a cost difference, in that if a company fires you, it may have an increase in its unemployment costs – and they’ve probably factored that in. This is a risky business – there are no gold watches in consulting, employee or contractor. (Of course, it’s not like there are gold watches anywhere else.) On the flip side, an employer that’s invested in keeping its people will do so, regardless of their type of work.

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