Independent contracter: what is the real 'net' pay.

behaviorkeltonOctober 21, 2007

I wasn't clear on an earlier discussion regarding the taxes on one's pay when working independently (i.e. there are no deductions).

So if you are in the 25% tax bracket (and no state tax)... does this mean that a $100 hourly fee is reduced to $75 net/take home pay? Is it that simple?

Someone mentioned other things... such as social security or Medicaid or something like that. Somehow, I thought this was a part of the 25%.

So in the end, what will that gross $100 look like once the damage is done? (What's the net?)

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It's much more complicated than that. When someone says you're in the 25% (or whatever) Federal bracket, it simply means that that is the percentage applied to your pay above a certain point; below that point the percentages are smaller. You have to look at the tax tables to understand at what points the percentages kick in.

In addition, you have a mandatory percentage you must pay into Social Security and Medicare up to a certain cutoff level (different for the two). Here is a quote from the Social Security website:

" The Social Security tax rate for 2007 is 15.3 percent on self-employment income up to $97,500. If your net earnings exceed $97,500, you continue to pay only the Medicare portion of the Social Security tax, which is 2.9 percent, on the rest of your earnings.

There are two income tax deductions that reduce your taxes.

First, your net earnings from self-employment are reduced by half of your total Social Security tax. This is similar to the way employees are treated under the tax laws, because the employers share of the Social Security tax is not considered wages to the employee.

Second, you can deduct half of your Social Security tax on IRS Form 1040. But the deduction must be taken from your gross income in determining your adjusted gross income. It cannot be an itemized deduction and must not be listed on your Schedule C.

If you have wages as well as self-employment earnings, the tax on your wages is paid first. But this rule is important only if your total earnings are more than $ 97,500. For example, if you had $20,000 in wages and $30,000 in self-employment income in 2006, you pay the appropriate Social Security taxes on both your wages and business earnings. However, in 2007, if your wages are $70,000 and you have $28,300 in net earnings from a business, you do not pay dual Social Security taxes on earnings more than $ 97,500. Your employer will withhold 7.65 percent in Social Security and Medicare taxes on your $70,000 in earnings. You must pay 15.3 percent in Social Security and Medicare taxes on your first $27,500 in self-employment earnings and 2.9 percent in Medicare tax on the remaining $800 in earnings."

Finally, even if your state has no personal income tax, there may be requirements specific to your state or your profession that, as a self-employed person, will involve other payments/deductions. You would need to call up your State Department of Labor and ask them what taxes/fees apply in your situation. Then you would need to project how much income you would expect to have come in for the year. Then you would need to figure out all the personal and business-related deductions that would apply, and then compute what your taxes would be using the appropriate tax forms.

Sound complicated? Absolutely. Your simple question has no simple answer and there's no way you can get a good answer on this forum. I would recommend that you talk to an accountant about what's involved in this. If you need to realize a certain amount of net income each year, professional advice on taxes is the only way you can probably figure about what you need to charge on an hourly basis.

    Bookmark   October 21, 2007 at 2:13PM
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The previous poster is right that there's no easy answer. I can tell you, though, that I have a solo law practice and speak with dozens of other sole practitioners, all of us in about the 25% bracket, and we all plan on paying out about 1/3 of gross in taxes of one sort or another, including state and social security. If I make quarterly tax payments that total 1/3 of gross, I never end up owing anything.

This is just a general rule of thumb, which may or may not work for you.

    Bookmark   October 21, 2007 at 9:49PM
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Thanks. Yes, I was looking at the 25% and then the additional 15% in social security/whatever... and thought, "good grief! Is this Canada?"

You're right... things are bit more complex than my question indicated.

Thanks also for the information about deductions.

One more question:
If I use a standard tax preparation program (ex: "TaxCut"), can I expect that it will deal with self-employment appropriately?

    Bookmark   October 22, 2007 at 8:44AM
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Hi BK. Folks have given you the right info and I agree the tax angle is complicated. From your other posts I'm guessing you may be considering a bit of part time independent separate from your salary and all this side of the 97k cutoffs. Or is it the big leap? Either way, the 25% fed and 15% SS is a reasonable ballpark start for your thinking. 60 cents on the dollar. Better than my 50 cents! (higher bracket + 6.5% state). But there are many other factors that take that 50 cents and chip it down to 25-35 cents, maybe less.

Having leaped from the security of civil service to independent contracting myself, I'll offer a couple other variables you may want to consider:

1)You will have costs, probably more than you expect. Everything from phone calls to postage to pens and paper will cost you - even if your "product" is your knowledge/consultation, there are still costs in the "production" of that service.
2)Good news is that some things you pay for anyway out of pocket now, eg pens, phone, computer, etc can be paid for out of your business using pretax dollars and that helps. Don't go nuts, and do be prepared to justify what you subtract off the top for expenses, but do consider ALL your expenses.
3)Consider also the costs of suppport services. Some you pay for: accounting, legal, etc and some you do yourself: you will have to maintain an accounting system, do your invoicing and billing, type your letters and xerox and fax yourself, return calls, make (and get to)appointments, respond to information requests, etc. All things that are done by others or done "on the clock" in your civil service position. All take time, none are billable, and they eat into your bottom line.
4)Speaking of time, you can bill only the hours you work, and that can be hard to keep steady. You may not have much work, expecially at first, but later you could end up overscheduled because you don't want to burn a referral bridge. And there is the No show = no work = no pay problem.
5)Understand sometimes people won't pay their bills. They just don't. You can't write that off in a cash based service practice. It is time (=$) just gone. I really hate that.
6)And of course there are huge costs of health & liability & malpractice insurances AND retirement funding if this would become your sole income.

Even without an office or any employees (really complicated situation) there is a lot to consider in addition to the taxes. Suddenly that $100/hour may not look so good against a $25-35/hour salaried position. But the autonomy and freedom and ability to control my schedule and workload all makes it worth it for me.

Good luck.

    Bookmark   October 22, 2007 at 12:41PM
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As for tax programs, I've used TurboTax Home and Business for years, and find it does a good job. I use Quicken Home and Business to handle both my home and office books, and it feeds right into TurboTax. Lots of my friends went right out and bought QuickBooks, only to find that you don't really need it for a small office.

    Bookmark   October 23, 2007 at 2:00PM
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I'm a "wage slave," and I lose 1/3 of the gross to taxes. Of course, I have state AND city income taxes.

I have no idea what would happen if I were an independent contractor.

    Bookmark   October 24, 2007 at 4:05PM
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I'm thinking there are so many hidden costs in being an independent contractor that I would have to account for even before getting to taxes. For example, contractors don't get holiday or vacation pay (or at least I don't think they do), so if they don't work, they don't get paid. That's about 30 days of zero income (10-12 national holidays and 15 days of vacation and throw in a few days of sick leave) I have to make up. Then there's the retirement, insurance, and equipment.

    Bookmark   October 31, 2007 at 4:34PM
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