Everything you need
to know about the self-employment tax.
"Don't
independent contractors pay higher taxes?"
This is a question I
get all the time from friends and colleagues who have yet to take the plunge
into 1099 contracting. This common misconception is the result of a
misunderstanding of a half truth.
Half-truth - As an independent contractor, you
will pay Medicare and Social Security taxes (FICA) that are twice as high when
compared to a full time W2 employee making the same amount of money.
Whole-truth - W2 employees only see that they
pay half of the Medicare and Social Security tax, because their employer is
paying the other half behind the scenes. But, as I've pointed out several times
on this site, any employee related expense that an employer is paying is REALLY
being paid by the employee. Don't trick yourself. This additional tax is just
part of the overall benefits package, and employers aren't giving benefits away
for free. This tax, just like health insurance,
sick/vacation days, and an office, has a monetary value and reduces the amount
of money an employer is able to pay you in salary.
Let's break this
down and use some real numbers. As of 2018, Social Security is taxed at a rate
of 12.4% on the first $128,700 of net income. Medicare is an additional 2.9%
with no cap. A self-employed person will pay the entire 15.3%, while employees
will split the cost with their employer.
So let's return to
the original question - do independent contractors actually pay higher taxes?
My response is two-fold:
- When it comes to Medicare and Social Security taxes, I stand by my assertion that everyone pays the same amount, but not everyone knows how much they pay.
- To get a full picture, you need to look not only at Medicare and Social Security taxes, but income tax as well. When you factor in the plethora of tax deductions available to independent contractors, the final tax amount can be much lower for a contractor than an employee.
Final thoughts
- As an independent contractor, you will actually be able to deduct half of your self-employment tax (the half traditionally paid by the employer) as a business expense. This has the effect of somewhat lowering the overall burden of this tax.
- Warren Buffet famously claimed that he pays a lower tax rate than his secretary, and that's a whole truth.
Happy Contracting!
Jim Roberts