Transitioning From Employee To Contractor? How Can You Avoid A Tax Hit?

13 October 2015
 Categories: , Articles


If you've recently made the decision to step out of the employment rat race to work as an independent contractor, you may be eagerly anticipating your newfound flexibility and freedom. However, this freedom to set your own schedule, hours, and workload can sometimes come at a financial cost -- often in the form of increased payroll and Social Security taxes. Read on to learn more about the additional types of taxes you'll pay as a contractor, as well as some ways to put more of this tax money back into your pocket.

What additional taxes will you need to pay as a contractor?

All employees who receive a W2 at the end of the tax year, whether full-time or part-time, have a portion of their Federal Insurance Contribution Act (FICA) taxes paid by their employer. The total amount of FICA taxes assessed to each employee is 15.3 percent, of which your employer pays half (or 7.65 percent). These tax revenues are directed to Social Security retirement, Social Security disability, and Medicare payments.

Self-employed individuals are required to pay a tax that is equivalent in amount and purpose to the FICA tax but is instead titled the Self-Employment Contributions Act (SE) tax. As a contractor, you'll be required to pay the full 15.3 percent of SE tax assessed. However, the total amount of SE tax owed is calculated on 92.35 percent of your net earnings, rather than the FICA tax assessment on 100 percent of gross earnings, which can provide you with some relief.

Some states may also assess additional or alternative taxes on self-employed individuals, so it's important to review your state tax laws before taking the plunge to determine whether self-employment is a financially viable idea.

How can you reduce your tax bill?

Fortunately, there are a number of deductions available to self-employed individuals that can lower your total tax bill. In some cases, you may even wind up paying fewer taxes as a contractor than you paid as an employee.

  • Retirement contributions

While employees are generally limited to the $18,000 maximum 401(k) contribution and $5,500 maximum IRA or Roth IRA contribution, those who are self-employed are permitted to set aside both the maximum annual 401(k) contribution and another 25 percent of their net income into a 401(k) deferral. 

As a self-employed individual, you also qualify for a Simplified Employee Pension IRA (SEP IRA), which allows you to set aside up to 25 percent of your income or $52,000, whichever is lower. 

Because both types of retirement accounts can lower your taxable income on a dollar-for-dollar basis, this is often the most efficient way to reduce your tax bill to the same level (or even lower) than it was while you were an employee, while simultaneously putting funds aside for your future.

  • Home office deduction

If you work primarily out of your home, you'll likely be able to deduct a portion of the expenses associated with the business use of your home. These expenses can include phone and internet charges, your mortgage and property taxes, and even electricity. Taking advantage of this deduction can save you money on both ends -- you'll avoid the expenses of paying rent and utilities for a separate office, while recouping any additional costs you incur as a result of your business activities.

  • Property depreciation

Most self-employed individuals require at least a computer and internet connection to seek work, and some (like mechanics or woodworkers) require a more extensive (and expensive) collection of tools. If you're required to purchase equipment to help boost your business, and you use this equipment for more than a year, you may be able to recapture some of your costs by deducting depreciation on your taxes. This process is usually more complex than can be handled by do-it-yourself tax software, so you'll want to make an appointment with a tax attorney or accountant, such as those found at Wiesner & Frackowiak, LC, to ensure that you're taking full advantage of all deductions available.