It’s easy to get confused about the difference between an independent contractor or an employee. Each type of work has its pros and cons, and your personality might be better suited to one style of working over the other.
You may become an independent contractor by choice and manage your own business, or you may end up as an independent contractor because your employer changed your status from a full-time employee in order to reduce headcount, for example. Regardless of the reason, understanding the facets of working independently can help you decide whether the move makes the best sense for you and your family.
What Is an Independent Contractor?
An independent contractor is an individual in business for themselves, providing goods or services to another individual or business. The independent contractor is a separate business entity and is not considered an employee. Independent contractors can work in a variety of roles, such as consultants, agents, or brokers. Others might be creative professionals or technical/IT types.
Most employees don’t have a written employment contract unless they work under a union contract or are highly-paid executives. But an independent contractor should always have a contract. It’s a good idea to get a written contract from each person or business for which you work. It defines when the work period is over, what happens if one party wants out, and what happens if one party can’t fulfill its obligations. A contract can settle many disputes before they start, and you can take a contract to court to get paid, if necessary.
The IRS has established specific tests to determine whether a worker fits the description of an independent contractor or an employee, which factors into how the individual and the employer, if applicable, need to handle taxes on wages or contractor payments.
Benefits of Self-Employment
There are some major benefits to being an independent contractor, including more freedom and the ability to deduct expenses.
It sounds obvious and that may be one reason why you are considering this change. As an independent contractor, you don’t have to work for someone else. You may be able to set your own hours and complete work assignments whenever you choose, depending on the type of job. You should be able to negotiate pay rates and a payment schedule, but you may still have to keep a timesheet if you are working on an hourly rate.
No Tax Withholding
Some people consider it a benefit that the payments you receive as an independent contractor don’t have any federal or state income tax withheld, or any FICA taxes (Social Security and Medicare taxes). However, you must instead pay these taxes on your personal income tax return. And since you won’t have an employer to share FICA taxes with you, you will have to pay a self-employment tax.1
Deducting Business Expenses
All the expenses you must pay to run your independent contractor business are deductible to you as business expenses. That includes business travel and the costs involved with having a home-based business. You’ll have to file a business tax return to take the deductions, but it’s worth it to minimize your income and your income tax liability.
Drawbacks of Self-Employment
There are some significant negatives to working as an independent contractor, especially when it comes to financial stability and a lack of benefits.
No Guarantee of Income
Being independent also means you don’t get a regular paycheck. If you are lucky enough to work for one or more clients who pay you regularly, that’s great. But the money can stop at any time, even if you have a contract. If there’s no work for you to do, there’s no money. It’s important to have savings to tide you over in case your clients don’t have immediate work for you to do.
Paying Business Expenses
If you work for someone else, they provide the office and the computer and everything else that goes with it. While you can deduct these expenses, you still must have the money to pay for them first. Some business expenses may not be deductible, and some might be deductible on a limited basis. For example, meal and entertainment expenses are only deductible at 50 percent of the amount.2 If you work from home, you can save money on some of these expenses.
No Benefit Plans
One of the main reasons people stay as employees is to have employee benefits, like health care, paid for by their employers. If you need health insurance, you can get it if you work independently, but you will have to pay for it all yourself. You can find health care coverage for self-employed individuals through HealthCare.gov. However, plans be expensive: in 2019, the average annual premium for single coverage was $7,188, and $20,576 for families.3
You Still Must Pay Taxes
As an independent contractor, you will need to declare all the income from your work on your tax forms, and you must pay taxes on that income. In addition to paying federal and state income taxes, you must also pay those Social Security and Medicare taxes (in this case, they’re called self-employment taxes).
Since no taxes have been withheld from your payments, you must pay these taxes by the tax deadline (April 15), along with your personal income tax return. You will need to make estimated tax payments throughout the year on a quarterly basis to avoid interest and penalties.4
Employee and Self-Employed Benefits
Employees and self-employed individuals can both contribute to retirement savings accounts. Employees can contribute through their employers, and if you are an independent contractor, you can find a retirement savings plan such as a SEP-IRA that fits your needs.5
Warning: This is an overview of information about independent contracting and should not be construed as advice. Talk to a tax professional or attorney about the benefits and drawbacks before becoming an independent contractor.