Independent contractor - this term can be used interchangeably with freelancer and self employed, and in this post I’ll just use IC for short. Generally, an independent contractor is somebody who works for themselves. You have your own tools for doing the job, and no payer has control over your work hours - they just have control over the result of the work, but you have the freedom of how you want to get to that result.
This can be from starting your own business, or it can be contracting your skills to one or many companies / individuals and getting paid for your work.
There is so much to say about being an IC, but today’s topic of course is - taxes. Being an IC changes a lot with not only your tax return, but your ‘benefits’ as well. No longer do you have an employer giving you options for health insurance, disability / life insurance, a retirement plan with a match, etc. You have to create that all for yourself.
Beyond your benefits, the hardest shift when becoming an IC is understanding your taxes. First step - read through a Schedule C. This is what you’ll be filling out when it comes time to report your income and expenses over the prior year.
Next step, understand how your new taxes work.
Net Income = Taxable Income
We all didn’t take business classes in school (or pay attention to them), but the terminology that seems to mix many people up is gross vs. net. When it comes to income, gross income is ALL the money you made. Net income is the money you made AFTER expenses - or the bottom line.
This bottom line is what ultimately gets taxed when you’re an IC, so make sure throughout the year you are tracking and recording your business expenses, because this will save you tax money.
Hit my link above for the Schedule C and check out the form to see some of the common business expenses (under Part II of the form). A deductible business expense is one that is “ordinary and necessary”. Yup, pretty vague, but that brings some freedom into making a case as to why your expenses are ordinary and necessary for your business.
Pay attention to a few personal things you use that you need for both your personal life and your business. For me, that includes my office, my laptop, my phone and my internet. I deduct a portion of all these that are used for my business - just make sure you understand the rules to each of these because they can be very specific (especially home office).
In an overly simplified world, another word for net income is profit. Businesses are taxed on their profits, and how much they are taxed depends on a few items:
Self-Employment Taxes
I wrote a long boring post on these taxes last year. Many say “omg, don’t self-employed people pay so much more tax??” And to that I say “nah”. But as always, it depends.
Self-employment taxes are also called payroll taxes - and everybody pays them! The difference is as an employee, you pay half of the payroll tax and your employer pays the other half. As an IC, you’re considered both employee and employer - and therefore have to pay both portions, or typically double what your employee counterpart pays.
How much? Up to the wage base of $147,000 in 2022, you pay 15.3%, whereas employees pay 7.65% (and their employer pays the other half). If you make more than $147k, then the majority of that tax drops off. You can read my previous blog for more information on that if you’re interested.
Self-employment taxes are what cause the misconception that ICs pay so much more tax. Your self-employment tax gets reported and paid when you file your tax return - while employees have their portion of the tax withheld throughout the year, which ultimately doesn’t get reported on their tax return. Maybe your tax return as an IC shows a lot more tax, but that is only because an employee doesn’t report the thousands of dollars they already paid throughout the year in payroll taxes (but ICs do report it). Employees - check your boxes 4 and 6 on your W-2 to see what I’m talking about.
BUT, all this to say; this is one piece of the tax puzzle you’ll have to be on top of when it comes to paying your taxes. The second piece is your federal and state income tax.
Income Tax / No Withholding
The US operates with a progressive tax system. As you make more money, you climb the “steps” aka tax brackets to a higher rate of tax - but that doesn’t cause all of your income to be taxed at that rate. Just each new dollar of earned income.
This is good news, but as an IC, the burden is now on you to calculate how much tax is due throughout the year.
Both your self-employment and income taxes need to be paid quarterly throughout the year (IRS rule, not mine) in order to avoid interest and penalties. Employees have it easy - they fill out a W-4 and their employer withholds both income tax and payroll tax on their behalf. ICs calculate their tax due each quarter, and send an electronic payment or check to the IRS / state department of revenue.
How much you should be sending is a whole post in itself. But there are a lot of calculators out there that can get you started. My best advice - start to understand and review your taxes every year so you know what they look like and can plan around them. This is a huge part of being a business owner (or, working for yourself) to get every advantage you can.
And, my last comment here is each state has its own tax system - both how your income is taxed and when "quarterly" payments are due. This is just another piece of the puzzle you have to be on top of.
Health Insurance & Retirement
These are a couple final expenses I want to point out. They technically do not get factored into your “net income” for your business, but they are expenses that you’ll have to replace as an IC, since you don't have an employer that can provide them.
As long as you don’t have access to health insurance through a spouse or employer, you can get your own health insurance that will count as a deduction for income taxes - but not for payroll taxes (aka self-employment taxes).
The same goes for retirement contributions. If they are not Roth contributions, then you can get a federal income tax deduction for contributions, but it does not affect the amount of your self-employment taxes. A state income tax deduction depends on the state, because not all states follow the federal deduction for retirement plan contributions (sigh).
There are a lot of options for retirement contributions that all have their own rules. Again, this could be a whole post by itself. But some of the common retirement plans are an IRA, Roth IRA, SIMPLE IRA, SEP IRA, or solo 401(k). Each has its own rules about how much you can contribute, when you need to contribute, etc. (I'm feeling pretty good about my job security right now).
But, just because you no longer have a payroll deduction to a 401(k) or an easy option with health insurance, you shouldn’t neglect these. They are crucial to a comprehensive financial plan to protect you from disaster (health insurance) and help you save for your future (retirement account).
Final Thoughts
According to 2019 IRS data, about 27.8mm tax returns had a Schedule C attached, out of 157.8mm filed. This means that there were 27.8mm independent contractors / freelancers / business owners in 2019, or 17.5% of those who filed a tax return. It doesn’t mean they were full time IC, but they had some form of self-employment income.
And, I would only suspect this number has gone up since the pandemic started and the gig economy continues to expand to new services and opportunities.
Being an IC is complicated, but you can see you’re not alone. I recommend you take the time to go through your tax return, line by line, to understand everywhere you’re getting taxed. This way, you can prepare for 2022 set expectations so there are no surprises when it comes time to file quarterly payments and your annual tax return.
Additionally, get an accountability partner. As you can see, there are millions in the US going through this same situation - have someone you can talk to and hold each other accountable to complete your books and send quarterly payments.
This will certainly feel like a burden at first, but once you get the hang of it, you can turn it into an opportunity.