Why Friends Don't Let Friends W-2
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"As an independent consultant, does it matter how I get paid?”
Absolutely! In the U.S., being paid on a 1099 tax basis as a business instead of on a W-2 tax basis like a temp worker makes a huge difference to your profitability for two key reasons:
- You pay less tax.
- You save more for retirement.
Here’s how I figured this out.
Several years ago, as an independent consultant I did my taxes two ways using TurboTax® software. The first used my legitimate tax return that showed I was paid on a 1099 basis. In other words, I had received 1099 tax statements from my clients for that tax year; I did not have any W-2 tax statements. On this tax return, I took standard business deductions (for example, for my home office, supplies, and mileage), and I factored in my retirement contribution to my SEP IRA (Simplified Employee Pension).
Then I wondered what would happen if I had been paid on a W-2 basis through a staffing firm and maxed out my 401(k) contribution (assuming the staffing agency offered one). In this scenario, I could not take any deductions for business expenses because I was technically an employee of the staffing agency, not a self-employed business owner. I was stunned by the results.
On the tax return where I was paid on a 1099 basis I owed $8,000 less in tax!
The reason for these tax savings was only partly due to the business-owner tax deductions. The real ticket to tax savings was the contribution to my SEP small business retirement account. By putting away $20,000 for retirement, I lowered my taxable income by $20k, much more than I would have if I had contributed to a traditional 401(k).
In addition to saving money on my current tax due, that money will grow tax-free for the next 25 years. When I retire, I’ll be in a lower tax bracket because I will be earning less, so the money I take out will be taxed at a lower tax rate than it would be now. I like knowing that I get to pay less tax two times (now and in 25 years) simply by saving for retirement. If you’re self-employed and you don’t have a solo 401(k) or SEP-IRA, you should!
One caveat—tax savings like mine may not hold up if you make less than $125,000 a year. This is because of the self-employment tax. As a self-employed business owner, you have to pay the employer’s share of your Social Security and Medicare contribution or 15.3% of your taxable income. This jumps to 16.2% if your gross income is greater than $200,000 in a calendar year. If you are paid on a W-2 basis as a temporary employee, the company issuing that W-2 statement will pay this part of the tax for you. To get the same sort of tax savings I did, you need to have enough total income after business expenses to offset that employer’s tax contribution. Talk with your tax professional.
So what is the problem? Why am I even writing about this?
If you do any consulting work for a large corporation it is highly likely that you will be shepherded (or forced) down the contracting path toward a W-2 situation through a third-party agency. (If you want to know why, read my white paper about co-employment risk.) This infuriates me and is the topic of more blog posts to come, but here are some of the warning signs.
Red Flags Leading to the Costly W-2 Path
- Your client says, “Great, let’s get you set up! Someone from XYZ Company will be reaching out to you. They handle the paperwork for all of our contractors.” Firms to be wary of include PRO Unlimited, MBO Partners, ZeroChaos, TalentWave, Agile 1, and Rose International.
- You are asked to complete a W-2 tax form, not a W-9 form. (A W-9 form is what results in a 1099 tax statement at the end of the tax year.)
- You get an email requesting that you fill out an on-line form. It might say “Submit Business Information,” “Requisition Process,” or “Business Validation Screening.”
If you see any of these red flags, proceed with caution! Answering a question the wrong way can divert you to the W-2 path. I definitely will write more about this in the coming months, but if you get tripped up in the meantime feel free to contact me for some pointers.
Like some wicked witch luring children with candy, the vendor compliance screening can lead to other misperceptions:
“We’ll handle all of your paperwork for you!”
“You’ll get a direct deposit in your account every two weeks; you won’t have to wait for the client to pay you in 45 days.”
“You won’t have to pay quarterly taxes!” (Like employees, your taxes are withheld from your paycheck.)
And my personal favorite:
“You’ll be able to participate in our excellent 401(k) plan!”
Are these “treats” worth paying $8,000 more a year in tax? Remember, “Friends don’t let friends W-2!” You will pay less tax and watch your retirement account grow. Who would you rather give your money to…the IRS, a staffing agency, or the future you?
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See my related articles for self-employed professionals:
Check out my articles to advance our 1099-Not-W-2 cause (and share with your colleagues!)
- Paying a Consultant as a Temp Worker is a Costly Mistake!
- It’s Time to Recognize Professional Independents!
"Friends don't let friends W-2" is a registered trademark of ProKo Consulting LLC; used with permission, all rights reserved.
