It’s no secret the modern economy has changed the nature of the working relationship between workers and companies. Many firms have responded to cost pressures by changing how they hire labor in an effort to reduce staffing expenses and control costs.
As a result, many companies now hire independent contractors with strong personal brands for specific, discrete tasks and projects instead of finding more expensive full-time employees. Without knowing about this labor market change, distinguishing between contractors and employees can pose a challenge.
To understand the nuances between employees and contractors from a tax (e.g., 1099 vs W-2, payroll taxes, etc.) and cost perspective (i.e., compensation and benefits paid), as well as other important differences (e.g., company control), this post will walk through the differences between these two working relationships.
What is a Form W-2?
A Form W-2 reports an employee’s year-end amount of compensation paid, taxes withheld, and requisite pay information needed to file federal and state tax returns. The form includes a host of information including payroll taxes withheld, pre-tax benefits (e.g., 401k contributions, HSA contributions), etc.
An employer must submit this form to the IRS and provide copies for the employee to complete a tax return.
What is a Form 1099?
A Form 1099 comes in many flavors. For the purposes of this post, it will serve as a record that an entity or person, not your employer, paid you money. The law requires any payment for services in excess of $600 to submit a Form 1099 to you and the IRS.
Freelancers, independent contractors, or other gig economy workers receive Form 1099s from their clients. These documents reflect the money the client has paid to the worker.
The forms include your Social Security number or taxpayer identification number on it, meaning the IRS will have knowledge of you receiving the money. It will expect you to report this income on your annual tax return.
However, simply receiving a Form 1099 does not indicate you will owe taxes if you take advantage of tax savings opportunities. If you’re looking for other tax avoidance opportunities, learn how to pay zero tax on passive income.
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1099 vs W-2: What’s the Difference in Terms of Taxes?
Because of changing workplace needs, many people must work in a more independent capacity and hold down multiple jobs or lines of work to get ahead. Some do this by choice because it gives them freedom to pursue what they want most while also providing flexibility in their day-to-day lives.
These qualities are synonymous with achieving financial independence and can be an added benefit.
On the other hand, others work as independent contractors to get by until they can find more permanent employment with better pay and benefits. Until such a time comes, working as an independent contractor can be a suitable alternative.
When it comes to breaking down the differences between 1099 contractors and W-2 employees from a tax perspective, the two receive separate tax forms. Independent contractors receive a Form 1099 while employees receive a Form W-2.
As a contractor, Form 1099 shows your total compensation received by this company but holds you responsible for calculating and paying your own payroll and income taxes on a quarterly basis. As an employee, the employer withholds these payroll and income taxes on your behalf and remits them directly to the government.
When it comes to payroll taxes, an independent contractor, you pay not only the worker portion (6.2% for Social Security and 1.45% for Medicare) but the company share as well. Because you are considered the employer when working as an independent contractor, this results in a total 15.3% paid on your earnings in payroll taxes.
However, you can claim a self-employment tax deduction on one half of those taxes, thereby lowering the tax burden. While this still leaves you in the hole compared to an employee who only pays half, one benefit enjoyed by independent contractors, especially after tax reform in 2018, is the ability to deduct expenses related to their work.
The laptop, desk and chair you just bought for your home office? Check, check, check and check (you can even deduct expenses related to having a home office!). All deductible. Employees no longer have the same luxury.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.