This is a guest post from Anjali Jariwala, a certified financial planner (CFP), certified public accountant (CPA), and founder of FIT Advisors. She provides an overview of some of the important tax and savings consequences of being an employee vs. being self-employed. Anjali is a site sponsor, but this is not a paid post.
There are many pros and cons apart from the tax consequences that will drive your choice of employment setting. Your net income and ability to save, however, will be a significant component of that decision. Understanding these differences can have a major impact on earning and saving potential, which in turn may impact your choice of jobs. Regardless of your current profession or income, this is information you should understand, as it can have a major impact on career.
Disclaimer: Anjali is not your personal CFP or CPA and I am not certified as either. All information taken from here is used at your own risk.
Should I be an Independent Contractor or Employee?
You are finishing up residency/fellowship and looking for a job and the question pops up, is it better to be an employee or independent contractor? This article will explore the pros and cons of each to help you make an informed decision.
What are the differences between the two? As an employee, you usually receive benefits from your employer like health care coverage, ability to contribute to an employer-sponsored retirement plan, and more. You will also have tax withholding done for you. What is withholding? Withholding is tax your employer takes out of your pay stub and remits back to the IRS on your behalf. The IRS requires everyone to pay in their taxes throughout the year. Failure to do so may result in penalties and interest. [Ed note: I recently heard on NPR a nice overview of the history of tax withholding – reading the transcript is quick and fun. You can find it here]
An independent contractor will not have withholding done on his/her behalf, so estimated tax payments are needed – this requires sending in 4 payments during the course of the year. So you both have to save the money to send it in, and do some basic estimations/calculations so you send in roughly the correct amount, or you could face an underpayment penalty. Further, as a 1099 income earner, you do not receive benefits such as employer-subsidized healthcare, so it is important to negotiate a higher pay to offset the fact you are paying for your own benefits.
An important tax difference between an employee and independent contractor is Social Security and Medicare tax. Social security tax is 12.4%, but is only taxed on the first $127,200 of your wages – income earned past that amount is not subject to the social security tax.
The Medicare tax is 2.9% and has no cap — every dollar you earn is subject to this tax. There is also an additional Medicare tax of 0.9% if wages exceed $200k for an individual and $250k for a married couple.
As an employee, you are required to pay 50% of the social security and Medicare tax, and your employer pays the other 50%. As an independent contractor, you have to pay the full 15.3% (plus the extra 0.9% if you are a higher wage earner as mentioned above). Either way, these taxes are in addition to your federal/state/local income tax.
Having to pay the full 15.3% is known as self-employment tax. You receive a deduction for one half the self-employment tax as an independent contractor.
Why would you want to be an independent contractor?
There are benefits and tax planning strategies that are available as an independent contractor that you cannot get as an employee. When you receive income as an independent contractor i.e., your income is reported on 1099 form instead of a W2, you are considered a business owner and are able to offset your income with business expenses.
What do you mean by business expenses?
For example, if you are required to drive to multiple hospitals for your shifts you may be able to deduct mileage or the entire cost of your car. Other business expenses may include association dues, cost of boards, medical licenses and more. Look carefully before making deductions; if you are unsure, consider consulting with a CPA to determine what are eligible expenses.
Your income is offset by these expenses and the amount subject to self-employment tax is the net profit of your business. What about health care premiums, isn’t that expensive if I have to get my own policy? Medical costs are rising so if you are paying for your healthcare out of pocket as an independent contractor, you can deduct the cost on page 1 of your tax return.
What about retirement plan contributions?
As an employee, you are usually eligible to contribute to a tax deferred retirement plan such as a 401(k) or 403(b) if you work for a government hospital. The maximum contribution for an employee is $18,000 a year. Your employer may provide a match or a profit sharing contribution as well.
As an independent contractor, you can set up a SEP IRA or Solo 401(k) for your business. The maximum contribution to these plans for 2017 is $54,000. This is made up of two parts – employee deferral and profit sharing (max of 25% of income). As a business owner, you may be able to put away the full amount whereas as an employee you usually cannot.
A Brief Example
Julie, an emergency medicine physician, earned $300k as an independent contractor. She offsets the $300k with business expenses of $50k so her net profit in the business is $250k.
Julie sets up an individual 401(k) for her business and contributes $18k as an employee. Since she is also the owner of the business, she can contribute another 25% of her $250k profit.
There is an overall cap of $54k so she can only put $36k of that $50k (25% of 250k) since she already contributed $18k as an employee. Thus, Julie effectively put away $54k into a retirement plan, which she receives a tax deduction on page 1 of her return. If July was an employee, she would be limited to depositing only $18k of her income into a tax-advantaged retirement plan, and would have to rely on an employer match for any additional retirement account contributions.
I keep hearing about S Corporations, what are those?
When setting up a business, it is important to set up a legal structure for your business. The most common legal entities are limited liability companies (“LLCs”) and Corporations. Check your state’s rules as many states do not permit medical professionals to set up an LLC and may be required to form a Medical Corporation or Professional Services Corporation. The main difference between an LLC and a Corporation is how the income is reported and who pays the tax on the profit. The net profit of an LLC is reported on the owner’s individual tax return. For a Corporation, the Corporation itself pays the tax and any profit the owner takes is taxed as a dividend.
An S Corporation is a hybrid of an LLC and a Corporation. With an S Corporation, the income “passes through” to the owner’s individual tax return like it would for an LLC. The benefit of an S Corporation is self-employment tax savings, mainly for Medicare (2.9% plus 0.9%). As an LLC, all of your net profit is subject to self-employment tax but as an S Corporation only the portion reported as salary and wages is subject to it. This means you can shield some of your income from self-employment tax. This is an area that is highly scrutinized by the IRS so it is important to select a salary that is reasonable for your specialty (editor: look online, ask colleagues, or consult with a CPA, or financial advisor to get a good idea). Generally, the amount of salary and wages reported usually exceeds the Social Security wage base of $127,200 so the savings is on the Medicare tax.
What if I am going to earn income as a W-2 and an independent contractor, should I still do the S Corporation election?
The answer to this question depends on how much is allocated to each bucket. When you earn income as an employee, you will pay the employee portion of Medicare and Social Security tax (up to wage limit) while your employer covers the other half.
If you also earn income as an independent contractor, make an S Corporation election and then take a reasonable salary you are subject to Medicare and Social Security tax on that income as well. These taxes are assessed by job so you essentially pay the Social Security tax on an amount higher than the wage limit of $127,200.
As an employee, you receive credit if you overpay Social Security tax but there is no credit as an employer. Thus, an additional calculation is required to see whether the S Corporation makes sense or if one is better off as a sole proprietor/LLC. There is an additional cost to have a CPA prepare the S Corporation return since it is a separate return so you need to weigh the cost of compliance with the potential tax savings.
I am totally confused…
These items can be complicated, but if you take the time to understand the differences, you will be highly rewarded by understanding the job implications.
If you have a complex tax situation you may want to consult with a CPA or financial advisor (Editor: if using an advisor, always make sure they are a fiduciary) to see what makes sense for your situation.
Other resources that may be of help: