Tax and Retirement Planning for Independent Contractors

One in five jobs in the United States is now held by a contract worker rather than a traditional employee, an NPR/Marist poll found in 2018. More and more physicians, as well as lawyers, accountants, and other professionals, are choosing to work as independent contractors.

In a traditional employment arrangement, an employer pays wages to an employee. They also offer benefits, including health insurance and retirement savings, such as a 401(k) match.

Employers also pay certain taxes on behalf of their employees. An employer pays half of the Social Security and Medicare tax on wages, and the employee is responsible for the other half.  The employer withholds the employees’ portion of taxes and withholdings Federal and State income tax to remit back to the IRS.

If you choose to work as an independent contractor, you’ll need to cover the full portion of Social Security and Medicare yourself, as well as ensure you are paying in your taxes throughout the year. You’ll also need to understand a new set of tax rules and retirement savings options.

Creating a business entity and making certain tax elections can help independent contractors reduce their tax liability. A few new rules from the 2018 tax overhaul give certain types of business entities more room to maneuver. Work with a CPA to understand how these changes affect you.

Understanding the self-employment tax

The IRS collects 12.4% of every U.S. taxpayer’s income for Social Security. This liability applies only to the first $132,900 of income (2019 limit).

The IRS collects an additional 2.9% of your income for Medicare, with no wage cap. Further, if your income exceeds $200,000 as an individual or $250,000 as a married couple, the IRS assesses an additional Medicare tax of 0.9%.

In a standard employer-employee relationship, the employer pays half of these taxes and the employee pays the other half. But when you work as an independent contractor, you are responsible for the full 15.3% (or 16.2% with the additional Medicare tax) — on top of what you owe in federal, state and local income tax.

Employers typically withhold these taxes from each employee paycheck and remit them to the IRS throughout the year. Independent contractors are supposed to do the same thing, typically in the form of four estimated tax payments throughout the year.

It’s difficult to know precisely how much you owe the IRS. But to be safe, plan to pay 100% of your current year’s tax liability throughout the course of the year. If you’re a high income earner, you will need to pay in 110% of the tax you paid last year in order to be “safe harbored.” Safe harbor means you paid in enough to avoid penalties and interest at tax filing time.

The IRS effectively considers 1099 workers business owners, which means some of the tax benefits available to businesses are available to you. Physicians may be able to deduct mileage for driving to different hospitals or professional association membership dues. Some contractors may be able to deduct healthcare premiums if they obtain insurance on their own. Work with a CPA to understand what you can deduct and what you cannot.

Finally, if you seek work as an independent contractor, remember to account for the additional tax burden as you calculate your cash flow — and negotiate accordingly for higher pay.

Should you set up legal entity for your business?

Once you’re earning a certain amount of income from 1099s, you may want to consider setting  up a legal structure for your business. Limited Liability Companies, or LLCs, are most common. An LLC is a “flow-through entity,” which means net profits are reported on the owner’s individual tax return. (Note, however, that LLCs are limited by some state rules. For example, medical professionals are not allowed to operate as LLCs in California.)

Corporations, on the other hand, are separate taxable entities, which means the corporation pays taxes on its profits. If the owner takes a distribution from those profits, it is taxed as a dividend. Thus, a Corporation has two levels of taxation.

An S-corp is a tax election that provides a hybrid option. Once you set up an LLC or corporation, you can choose an S-corp election to allow the income to pass through to your individual tax return.  As an LLC, all your profits are subject to self-employment tax. But as an S-corp, only the portion that you report as a salary is subject to the 15.3% self-employment tax — not the entire profits of the business.

The IRS scrutinizes S-corps closely, so it’s important to report a salary that is consistent with your specialty, as well as one that maximizes your ability to save for retirement. If you are unsure, consult with a CPA to see what is reasonable for your profession and experience level.

What is the Qualified Business Income deduction?

The Qualified Business Income deduction, or QBI, was created by the Tax Cuts and Jobs Act of 2018. It allows owners of LLCs, sole proprietorships, and other business entities — but not corporations — to deduct up to 20% of their business income on their individual tax return.

Some limitations: The QBI deduction is available to individuals who earn less than $157,500 as an individual filer or $315,000 as a married couple. (There is a phase-in range of up to $207,500 for individuals and $415,000 for married couples.) And it only applies to particular types of businesses.

If you are a service business, then you will not receive any benefit once income exceeds the thresholds listed above. If you are not a service business, there is a second calculation that applies based on wages and equipment acquired, so you may still receive a benefit even if income is higher.

Consult a CPA about whether you qualify to take the QBI deduction and whether it could reduce your tax liability. Now that it’s been in place for a year, tax professionals have a better sense of how this mechanism will work and who it’s best suited for.

Retirement planning for independent contractors

Independent contractors may be able to invest more in their retirement plans than their colleagues with traditional employment agreements.

Many employees have access to a 401(k) or a 403(b) retirement plan. The maximum annual contribution to those plans is $19,000; employers might match that or pay employees out of a profit-sharing agreement.

But independent contractors have a few other options: SEP IRAs and Solo 401(k)s. The maximum contribution to both of these types of accounts is $56,000 annually (2019 limit).

Independent contractors are still limited to $19,000 in employee deferrals, which they pay to themselves. However, they can save up to 25% of their income from the business in the form of a profit-share contribution, for up to a total of $56,000 in savings.

There is a difference on how each account is funded. With a SEP IRA, the entire $56,000 is funded through profit share, while a Solo 401(k) is funded with employee deferrals plus profit share. If your strategy includes Backdoor Roth IRAs each year, a SEP IRA would create issues with that strategy, while a Solo 401(k) would not. (Learn more about Backdoor Roths here.)

For example, let’s consider an emergency medicine physician who earns $300,000 per year working as a contractor. She set up an LLC for herself and has $50,000 in business expenses. That means she earns about $250,000 per year in profit. 25% of that profit is $62,500. Thus, she can contribute up to $19,000 as an employee, then up to $37,000 from her profits, to max out at $56,000 in savings for that year.

If the physician above elected S-corp status and took a salary of $150,000, her 25% profit share would be limited to her salary, not the entire net profit of the business.  However, at $150,000 of salary, she is still able to max out her retirement plan for the year.

I know I have mentioned this a number of times, but it’s worth one more reminder: a tax professional is an important partner in tax planning, especially if you earn income as a 1099. The IRS scrutinizes independent contractors and penalizes those who underpay. If contractors overpay, they are unlikely to get credits or refunds for those payments. A CPA can look specifically at your situation and find out what business entity, deductions and retirement savings strategy best fit you and your family’s needs.

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