ON THE MONEY
Hamill: Why does contractor pay come with a bigger tax bill?
Q: I am a stay-at-home mom with three children. Until last year, I worked full-time and made a very good salary. My husband also has a good salary and after some bad experiences with daycare, we decided that I would stay home until the kids started school. Last month, my former employer called me and asked if I would be willing to return. I said no, and they then asked if I could work 10 to 15 hours each week as a contractor. My health insurance is covered through my husband鈥檚 plan, so it does not bother me that this contractor work would come with no benefits. I negotiated an hourly rate that was 25% above what I had been paid as a full-time worker. I am now wondering what kind of tax issues I will have as a contractor rather than an employee.
I will speculate a bit about the family tax situation just to put some numbers to my response.
The 22% tax rate applies to taxable income from $96,950 to $206,700 for anyone qualifying as married filing jointly.
Taxable income is after all deductions, including the basic standard deduction of $32,200 for married filing jointly.
This means that you and your husband could have as much as $238,900 of positive income and still pay no more than 22% on any income.
The next highest tax rate is 24%, and that applies to taxable income as high as $394,600.
I will assume that any income earned by you, which is an increment above your husband鈥檚 income, will be taxed at 22%.
I will also assume that your New Mexico marginal bracket is 4.9%. This means that your total marginal tax rate is 26.9%.
If you itemize deductions, you can deduct the state income tax on your federal return, but I will assume that you use the standard deduction.
The income that you earn should also qualify for the 20% deduction for qualified business income (QBID).
This means that your 22% assumed federal tax rate will be reduced by 20%, so it will be an effective rate of 17.6%.
With this deduction, your combined federal and state tax rate is reduced to 22.5%.
Hopefully this sounds reasonably attractive to you. With your husband鈥檚 good salary, this should not sound like too high a burden.
I鈥檝e left something out. You will be a self-employed person and will have to pay self-employment (SE) tax on your net income.
This is 15.3% of the income. It is intended to replace the payroll taxes paid for Social Security and Medicare coverage.
The combined tax rate on your consulting income can then approach 38%. You pay almost as much SE tax as income tax.
There are a few adjustments made to the tax rate computations I just showed. First, you can deduct one-half of the SE tax paid against the income tax.
Second, the SE tax applies only to 92.35% of the net income that you earn from consulting.
This odd number is 100% minus 7.65%, which is what the employer typically pays for an employee, and claims a deduction for the payment.
Finally, the 20% QBID that applies for the income tax is reduced by the deduction allowed for one-half of the SE tax paid.
I鈥檓 sure that the three adjustments I just explained make little sense. They will not have a material impact on your total tax liability.
So, for planning purposes, let鈥檚 just say that you will owe 38 cents in total tax for every dollar of consulting income you earn.
I suspect that鈥檚 more than you were planning for. You will also have to plan for how you will pay the tax due.
The company will not deduct taxes from your self-employment income. You will need to plan for quarterly payments of the tax due 鈥� both federal and state.
One way to cover the tax is to adjust your husband鈥檚 withholding from his wages. This will be assumed to be paid ratably throughout the year.
The other way is to make estimated tax payments. These must be paid quarterly for both federal and state.
Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
