1099 or W-2? 5 things to know before becoming an independent contractor

We have heard it over and over again: Once you decide to work for yourself, you’ll never go back to working for someone else. Whether this mindset comes during a stressful period of unappreciation at a career that you have endured for decades, or it accompanies an entrepreneurial ambition straight out of college, almost everyone has felt it at some point. And how could one not?

The main pros of going independent may seem obvious:

  • The opportunity of unlimited income potential? Count me in.
  • Getting to decide my own working hours? Well, I’ve never been a morning person, so I am hardly productive before noon anyway…
  • Not having to travel to and work in the office? Traffic is a nightmare, and the coffee at the corner cafe is so much better.

Before we dive in, it is important for us to understand the main technical differences between a 1099 worker and a W-2 employee.

Becoming a “freelancer”

In recent years, a surge among millennials has led to an increase in technological, consulting and sales-related “freelancing” work. Entire businesses have arisen to provide these workers with flexibility in housing locations and coworking spaces in order to fulfill their move toward a different working lifestyle.

As the IRS states, a general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done or how it will be done. It is important to note that an individual cannot simply choose to be a 1099 or W-2 worker at will; it is a scrutinized area, and certain definitions must be met to classify as either.

While the glamour and attraction of self-employment is well known, there are many potential conflicts or restrictions that come with it.

Here are five important things to keep in mind before handing in your two weeks’ notice and diving into freelancing contractual work or self-employment.

1. Independent contractor taxes

Ah yes, taxes. How could we not start with the most inevitable aspect of life?

All kidding aside, it’s important to understand the difference in taxation between a W-2 and 1099 worker.

An often-overlooked disadvantage of being a 1099 worker is that there is no withholding of taxes by an employer. This means that unless you make quarterly estimated tax payments, you may end up owing a jaw-dropping amount of money every tax season or subject yourself to potential penalties.

To pile onto this, without withholding it may be hard to understand or gauge how much you are actually making as a 1099 worker. For example, a W-2 employee has the benefit of seeing their net pay (after withholding) on every pay stub, which can make it easier to budget, save and spend accordingly.

On the flip side, when someone works for themselves, the lack of tax withholding or estimation can lead to a “masking effect” that can hide a low rate of pay and come back to haunt them.

Additionally, many 1099 workers may pay FICA taxes as they are self-employed. This may not sound like a big deal, but it can be. A W-2 employee currently pays 7.65% of their income in taxes that go towards the funding of federal programs such as Social Security and Medicare. So, does this mean that a 1099 worker pays the same 7.65%?

Unfortunately, no. As a 1099 worker, you are considered self-employed; thus, you must also pay the 7.65% employer portion that is often forgotten about by W-2 workers. In the end, this means that a 1099 worker pays double the FICA tax (15.3%) as their W-2 counterparts (7.65%). This FICA tax is broken down between Social Security (12.4% that applies to the first $132,900 of earnings) and Medicare (2.9% that applies to all income earned).

Despite all of this, there are also some benefits.

To start, those who successfully set themselves up as a passthrough entity such as an LLC or an S-Corp could potentially qualify for a 20% deduction in taxable income. This is because the Qualified Business Income Deduction allows eligible taxpayers to deduct up to 20% of their Qualified Business Income (QBI).

Additionally, since it would be rare for 1099 workers to have access to employer-sponsored retirement programs, rules have been established that give them additional opportunities to save. Specifically, a SEP IRA plan allows for annual contributions that cannot exceed the lesser of 25% of compensation, or $56,000 in 2019. When comparing this to traditional IRA contribution limits of $6,000 annually ($7,000 if over the age of 50), an obvious advantage can be seen.

2. Irregular income

This one seems kind of like a no brainer, but it still needs to be mentioned. Similar to a commission-based income, self-employed individuals can see periods of incredibly high earnings, but also weeks (sometimes months) of little to no pay.

Other than the obvious stress that comes along with fluctuating salaries, many people find it difficult to budget accordingly or pay recurring bills in a timely manner.

If you think you can go without that extra streaming service or newest cell phone, think about larger expenses such as a car loan, credit card payment or mortgage. The inability to pay those monthly bills can impact far more than the right to use the service or property; it also plays a role in your credit score, and therefore your ability to borrow money in order to increase future opportunity. A great credit score can be a make or break factor when deciding to purchase a home, property or other large assets.

3. Lack of employee benefits

OK, so you may not have steady pay, but you have a feeling that your periods of high income will even out the droughts of a slow month or so. There are still other benefits (literally) that are provided by employers that, although well-known, are still important to fully understand.

To make positions more appealing and in an effort to retain talent, most businesses offer attractive employee benefits to coincide with the income that they pay their workers. And they’re not cheap. The average cost of employee benefits such as healthcare, dental care, life insurance, retirement savings contributions, disability insurance, etc. equates to roughly $11.00 an hour.

This means that although a self-employed individual can make an unlimited income, and that 1099 workers can be paid very handsomely by the companies that hire them, there is a catch. The lack of employer-sponsored insurance coverage, paid time off, education assistance, etc. can lead to out-of-pocket expenses that are unordinary, unexpected and costly.

4. Isolation

Picture this: It’s Monday morning, your first day back at work after a long weekend. The traffic was heavy on your way into the office, and you feel rushed. You open your inbox and bam, you’re hit with seemingly countless emails to add to your daily list of tasks. Wouldn’t it be great to work alone? Initially it may seem like a perfect idea, but think about this from a long-term perspective.

Being a member of a team comes with noted benefits. Many would argue that TEAM can be viewed as an abbreviation for Together Everyone Achieves More. Although this is hard to argue, as the benefits of delegation and collaborative brainstorming often lead to noticeable efficiency and innovation, one perk that is routinely glossed over is the positive impact that human interaction has on a person’s mental state or mood.

Working alone increases focus and leads to self-satisfaction when a job is accomplished, but who will you celebrate the victory with? Who will you confide in when the work gets overwhelming?

Studies have shown that long periods of isolation cause many to experience levels of loneliness and depression that can be helped by the presence of other people. A large part of personal development is derived from observation and collaboration with others — something that could be harder for a self-employed worker.

If you do decide to work independently, it may be best to build a network of other independent workers or professional development groups in order to help continue personal and professional growth.

5. Lack of job security

I hope you saw this one coming. Probably the biggest disadvantage of working as a 1099 worker is the overall lack of job security. Most 1099 arrangements are set up in a way that distances the company from the worker.

This may seem like an advantage rather than a drawback, but if your main source of income can be taken away with no obligation or real forewarning, you may want to think twice before setting off independently. 1099 workers can easily find themselves between jobs due to the constant fluctuation of market changes, or a potential shift for the demand of your craft.

Although the last 10 years have seen unemployment rates fall to record lows, a realistic employee would understand that this cannot last forever. Eventually, there likely will be a period of time when many Americans are out of work, unemployed or have given up on their job search.

What’s the best choice for you?

At the end of the day, many people may believe that the benefits of independency and unlimited income potential outweigh the risks and uncertainty of working as a contracted or self-employed worker. In fact, roughly 10% of the American workforce is classified as a 1099 worker, with the numbers expected to rise in the future years.

As with all things in life, you should make the decision that is right for you, and we strongly encourage you to seek help from your tax, legal and other professional advisors to make the correct choice clearer.

At Wipfli Financial Advisors, working in concert with the tax and business consulting professionals at our affiliate Wipfli LLP, we understand the complexities that go into this decision from financial matters standpoint.

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Pros and cons of being a contractor vs employee 1099 vs W2

Nathan Bodart
Nathan Bodart

Associate Advisor

Nathan Bodart is an Associate Advisor with Wipfli Financial Advisors, LLC, based in the Twin Cities.

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1099 or W-2? 5 things to know before becoming an independent contractor

time to read: 6 min