How to Climb Out of 1099-MISC Hell (and Another Rung Down – the 1099-NEC)
Box 1 of the 1099-NEC covers workers, fish, and attorneys. I’ll open: An Uber driver, a tilapia, and a lawyer walk into a bar...
It is March, and you’re doing your taxes. You enter the income from your W-2 and see that you are getting a refund. Next on your tax-paper pile is another form. Oh, yeah – it’s the $6,000 you earned in April of the previous year from your side job during Masters Golf Week working at Augusta National. You enter the $6K in from Box 7 of the 1099-MISC form and see a chilling change. That tax refund is now a bill due. What happened?
First, Realize That “Income” Is Taxed
It’s great to receive money. Your paycheck, holiday cash, rebates, dividends from stock your grandma bought a decade ago, a quarter at your feet. However, the money you earn today becomes part of your earnings this year and starts a “tax-owed” tab. Some money, like gifts or life insurance proceeds, aren’t taxed. But money you earn by working (or by having your money work for you by earning dividends) is taxed.
Second, Understand the Process When You Are a Regular Employee at a Job
When you earn income at a job where you are a regular employee, your employer takes care of many of the tax issues surrounding your income. There are two main types of tax burdens are:
Income taxes as a regular employee
Our Federal government taxes workers on the money they earn. Most state governments do, too. These taxes go on the Form 1040 (and the comparable state tax form) and with that form comes different deductions and credits that can help you reduce your taxable income. With each paycheck, your employer withholds (puts away for you) and sends to the IRS an estimated amount that goes to your annual tax bill. If your employer didn’t pull out these taxes for you, you’d have to do it yourself and send “Estimated Tax Payments” to the IRS because that revered entity is not going to wait until the next year to get its financial pound of flesh. As an employee, it’s no sweat because as much as you hate seeing your smaller paycheck, you are spared the hassle of sending income tax money to the IRS and your state government throughout the year.
FICA taxes as a regular employee
In addition to paying income taxes, our tax system requires that people who earn money pay into the Social Security (income when you’re old) and Medicare (health insurance for the over-65 crowd) systems, as mandated by the Federal Insurance Contributions Act. These taxes, commonly known as FICA taxes, are in addition to income taxes. The total tax rate for FICA taxes in 2020 is 15.3%. As a W-2 employee, you only owe half of that or 7.65% (6.2% goes to the Social Security fund; 1.45% is for Medicare) because your employer pays the other half (the other 7.65%, broken down the same way). Have you ever looked at your W-2 and felt depressed at how much comes out for FICA taxes? You have income tax coming out plus FICA tax. For example, if you earned $50K, your annual paycheck was reduced by $3,100 for Soc Sec and $725 for Medicare or almost $4,000, as well as being reduced by another $6,000 or more for Federal and state income tax. Unlike the income tax discussed above, there is no way to possibly reduce or have a lower rate of what is due on these FICA taxes. (Note: Another term for FICA tax is “Payroll Tax,” a term you heard during Covid-19 relief discussion.)
Third, See the Difference When You Are a Contract Employee, Freelancer, or Gig Worker
Income taxes for contract workers
In contrast to your regular paycheck, when you earn money as a non-employee, the “paycheck” you see has none of the FICA or income tax reductions you’ve grown accustomed to in a W-2 paycheck. You get all that money upfront, which is great! Until tax time. At that point, you have to pay the taxes. As a freelancer or contract worker, you still use the Form 1040 to do it, and it gets added in the same area as the W-2 information.
Do you have to pay those income taxes ahead of time the way you do with W-2 income? If you don’t earn a lot at your non-employee, 1099 job, you will probably be ok in not sending in tax payments ahead of tax filing day; however, since your employer isn’t withholding income tax and sending it to the IRS for you, if you earn a lot from your contract job, you’ll need to make those estimated payments yourself, either by check or electronically through the IRS’ EFTPS system. Think about it: our Federal government, through the IRS, wants to collect money all the year workers are making it, not just a lump sum of it the next April 15 almost a year later. That is why W-2 earners have taxes come out each paycheck and why 1099 earners maybe need to pay in taxes over the year. Another thing to be aware of is that from an income tax standpoint, you’re not going to have to pay a higher income tax rate on 1099-MISC income than you would on W-2 income, but if you earned mostly W-2 income and had a side job with 1099-MISC income, it will pop your tax bill up into an unpleasant surprise if you had not sent in tax payments ahead of time.
FICA taxes for contract workers
FICA taxes as a non-employee can be even more financi