When I first started looking for jobs after getting out of graduate school, I found that I had the option of working as either an employee or an independent contractor. At the time, I didn’t really understand the difference between the two situations in any detail. I only knew the difference between being an employee and being an independent contractor in the most general sense.
Since then, I have worked as both an employee, and as an independent contractor in different jobs. Through my professional experience and research, I have learned a great deal about the personal, financial and practical implications of both situations. And I hope the information presented in this article helps you understand which situation would be most appropriate for you. Understand that being an employee is significantly different than being an independent contractor, and the situation you choose will have a substantial and tangible impact on your life.
First let’s make sure we define the difference between an employee and an independent contractor. The IRS spells out the difference between the two categories on their website.
- EMPLOYEE – An employee is in business for an employer. The employer has control over the employee. The employer defines the job duties, sets the working hours, and supplies the materials need for the job. Basically in an employer-employee relationship, the employer has the authority to dictate what is done by the employee and how it must be done.
- INDEPENDENT CONTRACTOR – An independent contractor is a self-employed individual, and is also commonly referred to as a: consultant, freelancer, free-agent, or just a contractor. The person or business paying the independent contractor does not have day to day control over the the way contractor performs his/her job. The IRS says that an individual is an independent contractor “if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
Now that we know what an employee is and what an independent contractor is, we will look at some of the distinctions between the two categories in more detail. We’ll look at the differences in terms of: tax treatment, financial implications, and personal/lifestyle considerations.
- An employee only has to pay half of FICA and the employer pays the other half (FICA is the tax you pay to help fund social security and medicare). An independent contractor pays the full FICA tax, which is currently at a rate of 15.3%, this is known as the self-employment tax. As mentioned above, employees only pay half of this amount (7.65%).
- Since independent contractors are self-employed, they can often have significant business expenses which can be deducted from their income. This helps to reduce the tax burden.
- Independent contractors do not have any taxes taken out of their pay and must make estimated income tax payments quarterly. Employees have their income tax deducted from each paycheck. This means that the independent contractor has the responsibility of saving enough of his/her compensation to be able to pay the estimated quarterly tax when it is due.
- Independent contractors have the ability to defer taxes on a much larger portion of their income in the form of retirement account contributions. For example, an employee is typically limited to deducting an IRA contribution of $6,000 and a 401(k) contribution of $19,000 if a 401(k) is available. A self-employed individual can contribute and defer taxes on $56,000 when using a SEP IRA or solo 401(k). Check out our article on self-employed retirement account options. Being able to defer taxes on so much income is a significant advantage at tax time.
- Independent contractors are typically paid significantly more than employees. According to the Wall Street Journal independent contractors are typically paid 20-40% more on an hourly basis. The reason for this pay differential is because employers typically pay part or all of an employee’s benefit package. Because of this, employees are quite expensive, and an employer will reward an independent contractor for these cost savings in the form of a higher hourly pay rate.
- As mentioned earlier, independent contractors typically have business expenses. Although these expenses are tax deductible, they are still expenses and must be considered. Business expenses for employees are typically minimal.
- Independent contractors have to obtain and pay for their own benefits and work-related insurance (disability and liability insurance). Employees normally have benefits provided by, and at least partially paid for, by their employer. The cost of medical insurance in particular can be a very significant expense for an independent contractor.
- Independent contractors can not claim state unemployment benefits if they lose their contract.
- An independent contractor has the potential to negotiate his/her own pay increases with each new contract. This is an advantage when compared to the typically smaller periodic salary increases for employees.
PERSONAL / LIFESTYLE
- Independent contractors can usually set their own hours and perform their job however they want. The feeling of independence is a valuable advantage that gives you more control over your life.
- As an independent contractor, organizing and paying for your own benefits can be stressful personally and financially. Setting up your own benefits requires you to do some research into the types of insurance you want and need.
- Independent contractors do not have the same stability and security of predictable income. Employees with a set salary will get their paycheck every week even if business is slow for their employer. The income of an independent contractor can be much more variable depending on how much work is available at any given time. When an independent contractor is being productive there is the potential for very high income, but when business slows, there is the potential for low income or no income at all.
- As an independent contractor, there is normally no such thing as paid vacation or personal days. If you don’t work, you’re losing out on income.
- You will be responsible for managing your own business. You have to find and contract with clients, figure out how you are going to perform your work, and submit invoices so that you can get paid.
Keep in mind that sometimes the lines between employee and contractor can become somewhat blurred. For instance, there are some independent contractors with very reliable long-term work that resembles more of an employee lifestyle. On the other hand, some employees have great freedom over work hours and how they perform their job, making their lifestyle seem more like that of an independent contractor. But regardless of how a job “feels” it is important to remember the financial and tax implications associated with your job category because you will be feeling those aspects of your job every day.
The choice between being an employee and an independent contractor is not an easy one or an obvious one. As you can see, both situations have very significant pros and cons.
A job can work out wonderfully as an an employee or as an independent contractor. The important thing is to understand the distinctions between the two situations and how those differences will affect your life and the life of your family.
After having worked as an employee and an independent contractor, I can tell you that it is a personal preference and there is no right or wrong answer. I enjoy the freedom and control of being self-employed and can accept the potential risk. I wouldn’t want it any other way. Whatever choice you are leaning toward, be sure to educate yourself as much as possible about the many ways in which your decision will affect your life, for better and for worse. As long as you learn what you need to know, you will make the right decision.