Taxes. One of life’s certainties. While unavoidable, following the correct financial plan can make sure your taxes are at least manageable, especially as an independent contractor. Being a contractor means that you will pay taxes quarterly, rather than paycheck by paycheck as a W2 employee. We spoke with CPA Gary Topple and CFP Adam Cmejla about how to manage your taxes this way.
What's the difference between a W2 and a 1099?
As a wayjourner, processing your taxes from your W2 is automatic. Your employer does it for you and makes it very simple. As a contractor, however, you have to set aside enough money independently for when you have to make a payment.
The government provides a “safe harbor” for your total tax. This means the IRS looks back at the previous year’s taxes, and if, for example, you paid 110% of the previous year’s tax, so long as you’ve paid enough to cover that, you can pay the balance on April 15th.
Dr. Geller recommends setting aside a separate account as a tax account that keeps the payment set aside.
However, Gary Topple raises an interesting question: what if you’re making slightly less than last year? As a contractor, your income can fluctuate, and setting aside 110% of last year’s taxes may be inconceivable this year. Your other option then is to put away 90% of the current year’s tax. You still have to make quarterly payments, but sitting down and planning out what those look like based on your current income is something you can do alongside your accountant.
Let us help you get started on your plan. Download our Personal Cash Flow Calculator at the end of this article!
It’s also important to know that “every new grad OD is in safe harbor, they just don't know it.” New grads may not know what they don’t know, and this can lead to a situation where they receive their first paycheck with a large statement on it. They’ve had summer jobs, fill-in work, etc. in the past that had taxes automatically deducted.
If they proceed to file their return as a W2 employee because they didn’t know they were getting paid differently, they’ll be in the red. As Adam Cmejla puts it: “the balance will be in the red. It’ll be 4-5 digits in the red.” They will be responsible for the full tax bill that’s due April 15th for the entirety of the previous year on top of the first quarter of the new year in order to catch up on the quarterly payment system.
To keep on top of this cycle, remember, it is much more cost effective to be proactive with your personal and tax planning.Ultimately, it may cost you more to not hire someone to help with these things. Rather than summarizing, the best bit of advice Dr. Geller was able to give was simple: “Just talk to [your financial planner].”
Not quite sure where to start with financial planning? Download our Personal Cash Flow Calculator below!
Download the cash flow calculator now!
Create your personal cash flow statement with this handy tool!