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1099 vs. W-2 Employment: Understanding Which Is Best for You

You just received an employment offer or are considering a side hustle, but the dreaded 1099 comes up. While a 1099 does force you to report your earnings on your tax return, it can also come with added benefits, like flexibility, the ability to claim deductions, and more. The key differences between a 1099 and W-2 employment lie in the tax implications, employee benefits, and the degree of control over the work.

Tax Implications:

  • W-2 Employees have taxes withheld from their paychecks by their employer, covering federal and state income taxes, social security, and Medicare. Employers are responsible for covering half of the Social Security and Medicare taxes (also known as payroll taxes).

  • As a 1099 contractor (or self-employed individual), you’re responsible for your own taxes, including self-employment tax, which covers both the employer and employee portions of Social Security and Medicare taxes. Generally, you may be required to make estimated tax payments throughout the year too.

Employee Benefits:

  • W-2 employees often receive benefits like health insurance, retirement plans, and paid leave. They are also covered by labor laws such as minimum wage and overtime pay.

  • As a 1099 contractor, you do not receive these benefits through your customers and are not protected by most labor laws.

Control Over Work

  • W-2 employees generally work under their employer’s control regarding how, where, and when the work is done.

  • As a 1099 contractor, you have more freedom and flexibility in how you complete the work but you have less job security.

Payroll Taxes for W-2 and 1099 Workers

One of the biggest differences between W-2 and 1099 work is how payroll taxes are handled.

W-2 Employees

  • Social Security and Medicare taxes (payroll taxes) are split between the employer and the employee. Each pays 7.65% (6.2% for Social Security and 1.45% for Medicare) of the employee’s earnings.

  • For example, on a $50,000 salary, both the employee and the employer each pay $3,825 in payroll taxes.

1099 Contractors:

  • As a self-employed individual, you are responsible for the full amount of Social Security and Medicare taxes, known as self-employment tax, totaling 15.3% of your total earnings.

  • On an income of $50,000, you would pay $7,650 in self-employment tax.

As a 1099 contractor, you bear a higher payroll tax burden, since you cover both the employee and employer portions. However, you can deduct half of the self-employment tax when calculating your taxable income.

Cash Flow Considerations for Employees and Contractors

The way payroll taxes are handled also affects your cash flow in each situation:

W-2 Employees:

  • Taxes are withheld from each paycheck, including federal and state income taxes, Social Security, and Medicare. This reduces the take-home pay but spreads out your tax obligations throughout the year.

  • For example, if as a W-2 employee, you earn $5,000 per month, your net pay might be around $3,750 after tax withholdings.

1099 Contractors:

  • As a 1099 contractor, you receive gross payments without any tax withholdings. You are responsible for making estimated tax payments quarterly.

  • A 1099 contractor earning $5,000 a month receives the full amount. However, you need to set aside a portion for taxes, which might be around the same $1,250, to be paid later.

W-2 employees have a more consistent and predictable cash flow, while 1099 contractors experience higher cash flow upfront but must actively manage their tax obligations. As a 1099 contractor, it’s super important to budget and regularly pay your taxes to avoid large year-end tax bills and potential penalties.

Calculating the True Cost of Employment

You need to understand the true cost of an employee to a business to make an informed decision about which status is more beneficial to you. The true cost of an employee extends beyond the basic salary, and encompasses various additional expenses like the following:

  1. Salary: This is the base cost, the agreed-upon wage for the employee.

  2. Payroll taxes: Employers must pay their portion of FICA taxes, which is 7.65% (6.2% for Social Security and 1.45% for Medicare) of the employee’s salary.

  3. Benefits: These can include health insurance, retirement contributions, paid time off, and other perks. Depending on the benefits package, this can significantly increase the cost, often by 20-30% of the employee’s salary.

  4. Other Expenses: This may include training, equipment, office space, and other resources necessary for you to perform your job.

In contrast, the cost of a contractor to an employer is typically more straightforward. It usually involves the agreed-upon rate for the services, without the additional expenses of payroll taxes, benefits, or resources. To offset this, contractors may charge higher rates than the equivalent employee salary to cover their self-employment taxes and lack of benefits.

For example, being hired as an employee with a $50,000 salary could cost an employer around $75,000 to $70,000 when factoring in taxes and benefits. In comparison, being hired as a contractor, you might charge a higher rate, but the employer saves on benefits and payroll tax expenses.

Making the Shift from W-2 to 1099

If you’re making the shift from a W-2 employee to a 1099 contractor, consider the following to maintain equivalent earnings:

  1. Account for lost benefits: Calculate the monetary value of lost benefits (health insurance, retirement contributions, paid leave, etc.). Add this to your base salary to understand your total compensation as a W-2 employee.

  2. Self-Employment Taxes: As a 1099 contractor, you’ll pay both the employee and employer portions of Social Security and Medicare taxes, totaling 15.3% of your total earnings. This is more than the 7.65% typically deducted from a W-2 salary.

  3. Calculate the Necessary Salary Increase: Factor in these additional costs to determine your required rate. For example, if your W-2 salary is $50,000 with $10,000 worth of benefits, the equivalent 1099 income might be higher to account for self-employment taxes and lost benefits. You might need to target $70,000 or more as a 1099 contractor to maintain equivalent net earnings.

  4. Irregular Cash Flow: As a contractor, you’ll receive gross payments without tax withholdings and need to manage your cash flow, setting aside funds for taxes and other expenses.

Transitioning to 1099 status can offer more autonomy and potentially higher earnings, but requires careful financial planning to ensure the change is beneficial.

Advantages of Being a 1099 Contractor

Still, being a 1099 contractor comes with several benefits that could offset all the downsides I mentioned above:

  1. Claiming Business Expenses: As a 1099 contractor, you can deduct a wide range of business expenses that W-2 employees cannot. This includes office supplies, travel expenses, home office costs, and equipment. These deductions can significantly reduce your taxable income.

  2. Tax Structure Flexibility: Contractors have the option to structure their business as an S-Corporation. While you still draw a salary (and pay payroll taxes on it), any additional business profit may be distributed as dividends, which are not subject to self-employment taxes, potentially leading to significant tax savings.

  3. Increased earning potential: Contractors often can negotiate higher rates than what is typically offered to salaried employees. They can also work with multiple clients, which can further increase earning potential.

  4. Work Flexibility: 1099 contractors usually have more control over their work schedule, choice of projects, and work location, offering a better work-life balance or the ability to pursue a variety of interesting projects.

  5. Retirement Savings Options: Contractors have access to retirement savings plans like SEP IRAs or Solo 401(k)s, which often allow for higher annual contributions compared to traditional IRAs available to W-2 employees.

These advantages can make 1099 contracting an attractive option. However, it’s important to weigh these against the loss of steady income, benefits, and job security associated with W-2 employment.

Legal Implications of Employment Status

It’s not enough to be considered a 1099 contractor by your employer. In California, the legal framework for determining employment status under the “ABC test” distinguishes between employees and independent contractors based on three key factors:

  1. Autonomy in Work: You must be free from the control and direction of the employer in connection with the performance of the work

  2. Business distinction: The worker must perform work that is outside the usual course of the hiring entity’s business

  3. Customary Engagement: The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

This legal framework has significant implications. Misclassification can lead to legal and financial penalties.

Given the complexity and potential consequences of misclassifying employment status, both businesses and workers in California should consult with an employment law attorney to ensure compliance with state laws and to fully understand the rights and obligations.

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