The most important thing contractors should understand is that two separate federal taxes will be imposed on their income, and how to keep both taxes as low as possible. There's the regular tax, with its progressive tax rates. And there's the self-employment tax at a rate of 15.3%. The self-employment tax is similar to the Social Security and Medicare taxes deducted from an employee's paycheck. For employees, the employer pays half of these taxes and the employee pays the other half. Independent contractors, by contrast, pay both halves of this tax.
Both the regular tax and the self-employment tax are calculated on a contractor's net income. That's their income from their contract work after all business expenses have been deducted. Typical expenses for a contractor would include the cost of computers, software, travel to meet with clients, office supplies, and local business fees and licenses. Contractors will need to keep track of their income and expenses so that their tax is accurately calculated.
Some expenses, however, only reduce the regular tax and not the self-employment tax. This includes items such as health insurance and savings contributed to tax-deductible retirement plans. While this sounds like a lot to remember, the important thing to keep in mind is how different expenses impact your tax calculations so you'll be able to plan accordingly.
Contractors won't have any taxes withheld by their clients. That means contractors should set enough money aside and start making estimated tax payments. Figuring out how much estimated tax to pay can sometimes be as complicated as filing out a tax return. What I do is keep a very spreadsheet that I update four times a year. That way I can adjust my estimated payments throughout the year to take into account fluctuations in my income and deductions. Here's a sample calculation so you can see what sort of math is involved.
One of the nice thing about being an independent contractor is that there are several retirement plans designed specifically for self-employed persons. The most important plans are the SEP-IRA, SIMPLE-IRA, and solo 401(k) plans. Even if contractors have tight cash flows, setting up a retirement plan can pay off at tax time. Let me explain how. All three of these plans can be funded by your tax filing deadline, plus extensions. So even if cash is tight this year, you might be able to fund the plan next year and still take a tax deduction for the previous year. This provides greater flexibility in managing their tax calculations. But be aware that a SIMPLE plans must be set up before October 1, and 401(k) plans by December 31, even if contributions are funded in the following year.
Because of the extra records contractors will need to keep track of, I highly recommend they start using a financial software program. A spreadsheet application is often sufficient for most types of information. Personal finance programs such as Quicken, Microsoft Money, and the open source GnuCash are also recommended because contractors will be able to down data from their bank and retirement accounts into one location. Contractors who plan to expand their business by using subcontractors or hiring employees or who need to more reporting utilities to track invoices should look into a full-featured accounting program such as Quickbooks, Peachtree, or Microsoft Office Accounting. One word of advice: you'll want to spend more time doing contract work than you will using your financial software, so be sure to pick an application you feel comfortable using. For many, this will mean starting off with a spreadsheet, and then gradually working your way up to a more full-featured program as your needs change.
New contractors often wonder if they need to establish a formal business structure, a process called incorporating a business. There's pros and cons to consider. For contractors just starting out and for whom contract work might be a short-term situation, I would avoid forming a separate corporation or LLC. You'll want to first get a sense of how your finances look as an independent contractor and the types of financial, tax and legal issues you are facing. Then you'll be in a better position to weigh the advantages and disadvantages of each type of business structure. Plus, there are a variety of state and local fees and taxes that will apply once you form a separate business, so you'll want to make sure that taking this extra step will be cost effective for you.
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I’d say that the legitimacy and legal protection offered by incorporating makes it worthwhile in most cases.
Ted, I agree there are many advantages to forming a separate business entity. But for new contractors, especially if they are unsure about whether they will remain independent, it might be better to take a wait and see approach. That way they can get a sense of how their new venture is going, and be able to assess what sort of protections, legal and otherwise, they may need.