Woburn, MA (PRWEB) March 29, 2006
As April 15th looms, it is important for taxpayers who moonlight to distinguish whether they are compensated as an employee or independent contractor. Whether you moonlight to supplement your salary, pay down your student loans, or build a nest egg, how you're compensated determines how you will be taxed, explains Andrew Schwartz, CPA, founder of the MDTAXES Network, an affiliation of CPAs throughout the country that specializes in tax planning and preparation for healthcare professionals. If you havent completed your taxes for 2005 and arent sure how you were compensated last year, you could be facing a large tax bill on April 15th. If taxes are withheld from your pay, you're considered an employee. No taxes withheld means you're an independent contractor.
Generally, each employer has a set policy as to whether they compensate their moonlighters as employees or as independent contractors. Here are some of the advantages and disadvantages to being compensated as an independent contractor:
Advantages
Professional expenses can be deducted directly against income. If a person earns $10,000 moonlighting as an independent contractor, and has $6,000 of un-reimbursed professional expenses, he will pay taxes on only $4,000 of net moonlighting income. If he is paid as an employee, he will claim professional expenses as an itemized deduction subject to various limitations.
Independent contractors can establish and contribute money into a pre-tax retirement account based on their net moonlighting income. Individuals have until April 15, 2006 to set up and fund a SEP IRA for 2005 (or October 15 for those filing for an extension), and sock away up to 20% of their net moonlighting income. Amounts contributed reduce taxable income and grow tax-deferred. Other pre-tax savings opportunities available to independent contractors include SIMPLE IRAs and Solo 401(k) plans.
100% of health insurance premiums can be deducted. As long as a person is not covered under an employer sponsored health insurance plan, being paid as an independent contractor allows her to write-off her health insurance premiums paid during the year.
Disadvantages
Independent contractors are subject to an additional tax known as the “self-employment tax”. When someone works as an employee, their employer withholds social security and Medicare taxes from their pay at a rate of 7.65%, and then matches the taxes withheld. So the government gets 15.3 cents for every dollar earned. When a person is self-employed, they are required to report and pay that 15.3% tax, known as the self-employment tax, as part of their federal tax return. The self-employment tax rate goes down to 2.9% once a persons combined salary and net moonlighting income exceeds $90,000 for 2005 and $94,200 in 2006.
An independent contractors tax return becomes much more complicated. The days of preparing the 1040-EZ are over. He needs to complete and send in the long form, along with a Schedule C, Schedule SE, and whatever other tax forms and schedules might be required.
Independent contractors may be required to prepare and submit quarterly estimates. The government generally doesn't want taxpayers to write them a big check on April 15th. Depending on how much a person earn moonlighting and what else she has going on with taxes, she might need to send the IRS payment every quarter to keep from getting penalized. A 1040-ES form should be used to remit federal estimated tax payments.
Employee vs Independent Contractor:
Employee
*Receive W-2 Form
*Report income with other wages earned during the year
*Claim professional expenses as an itemized deduction
Independent Contractor
*Receive 1099-Misc
*Report income on a Schedule C
*Claim professional expenses directly against income earned on the Schedule C
Monitor Withholdings
Even if taxes are being withheld from a taxpayers moonlighting income, he should not assume that enough taxes are being taken out. That's because each employer withholds taxes as if they are the only employer.
For example, if a person earns $20,000 from three employers during the year, the amount of federal income taxes withheld from her pay will be significantly less than if she had earned $60,000 from just one employer.
To make matters worse, if an individual tells his employer he is married, they withhold even less taxes, since the withholding tables for a married person assume the spouse doesn't work.
The 40% Rule
Moonlighters who are paid as independent contractors have no taxes withheld. In that case, it's generally a good idea to set aside 40% of earnings for taxes. Moonlighters will owe federal taxes, state taxes, and self-employment taxes on their earnings.
Plan Ahead
The taxes you'll owe on your moonlighting income are manageable if you plan ahead. Don't let the possibility of a surprisingly large tax bill deter you from taking advantage of moonlighting or consulting opportunities that may arise, explains Schwartz.
Andrew D. Schwartz, CPA is the editor and a major contributor to http://www.MDTAXES.com, a website that provides income tax and financial planning information geared towards healthcare professionals. Schwartz has provided financial planning advice in interviews with various media, including the Washington Post and Wall Street Journal. He is available for interviews.