There are so many things to consider when you’re working for yourself. Flexibility, autonomy, creativity, and ownership may come to mind, but what about the financial aspect? Let’s hash out two primary differences between being a W-2 vs. a 1099 employee (or self-employed): Taxes & Benefits.
Retirement Accounts
- You likely can put more away in retirement accounts when you’re self-employed or receive 1099 income. Two common retirement plans are a Solo 401k or a SEP IRA. The maximum contribution in 2021 is $58K; more in a Solo 401k if you’re over 50.
- Which one is best for you? It depends on your appetite for administrative paperwork along with your income level.
- Because a Solo 401(k) allows “employee” contributions (SEP is “employer” only), you can have a lower salary and contribute more than a SEP IRA. Still, this is the one that requires more of an administrative burden.
- A Solo 401(k) allows your spouse to join, and you can design the plan to include a Roth 401(k) component.
- You can’t have any employees with the Solo 401(k), but you can with a SEP IRA.
- Other options: Traditional/Roth IRAs, SIMPLE IRA, and Cash Balance Plans. Don’t forget about an HSA, which is a fantastic retirement tool.
Benefits Given Up
- It’s worth noting what you are giving up when transitioning from an employer to self-employed: health insurance, paid time off, retirement plan employer match, fringe benefits such as long-term disability, group term insurance, workers compensation, and unemployment insurance.
- Of course, you may be getting the best of both worlds if your 1099 income is a lucrative side hustle.
Reimbursement of Business Expenses
- The qualified business income (QBI) deduction passed by Congress in 2017 allows a sole proprietorship or an owner of a pass-through entity to claim a deduction of 20% of QBI. Stated more simply, if you’re a 1099 employee or self-employed, you may be eligible for this.
- This deduction relies on complex rules favoring businesses of a specific size (phase-out ranges) and type (service-related) over others.
Business Structure
- Two common structures to consider if you’re a 1099 employee or self-employed are a Limited Liability Company (LLC) and S-Corporation (S-Corp).
- An S-Corp is an elected tax status, not a business entity like an LLC. You could be organized as an LLC but taxed as an S-Corp, for example.
- An LLC shields your personal assets from business creditors, but it’s a pass-through entity for tax purposes. In other words, the earnings flow through to Schedule C of your 1040.
- LLC owners must pay self-employment tax (Social Security and Medicare) for all income, whereas an S-Corp owner may pay less provided they pay themselves a “reasonable salary.”
- The “reasonable salary” is an important consideration. You need to make sure you’re profitable enough to pay yourself and realize the tax benefits of receiving a distribution not subject to self-employment tax.
- With an LLC, you’re responsible for both the employer and the employee portion of self-employment tax on the business’s gross income. Because of this, LLC’s receive an “above-the-line-deduction” for 50% of the self-employment tax paid.
- With the S-Corp, the business pays half of the self-employment tax, and the shareholders pay the other half on their “reasonable salary.” If there is money left over, the distribution is taxed at the shareholder level.
- One thing to keep in mind: shareholders of an S-Corp that own more than 2% of the business can’t claim employee health insurance as a tax-free benefit.
Planning your retirement plan options, QBI deduction, and your business entity can get complicated. If you’re a 1099 employee or self-employed, consider consulting with a financial advisor and tax professional. Why not do everything you can to make sure you’re set up for success? Let us know if we can help.