Consultant or Employee?

For part-time or consulting work, how are you classified by your employer: as a consultant or as an employee?

Since we're primarily talking about taxes in this post, the difference is that an employee receives a "W2" and the consultant receives a "1099" each year from their employer. These forms -- provided to you and the IRS -- document how much you earned in a given tax year. The type of form you receive is important because the tax treatment of W2 income and 1099 is very different.

Employee:
Hiring you as a consultant instead of as an employee, your employer saves a lot of money in taxes. The biggest is Social Security tax -- employers are required to pay the SSA 6.2% of your salary below $97,500. Medicare tax adds on an additional 1.45% of your pay. And don't forget about unemployment, disability and other taxes which your employer pays on your behalf.

When you get paid as an employee, you pay the other half of your "payroll taxes": 6.2% of your wages for Social Security, and 1.45% for Medicare. If you incur any job-related expenses which you don't get reimbursed for, you can deduct them on your taxes. But there's a catch: your unreimbursed-job-expenses are not an "adjustment" to your income. Instead, they are considered a "miscellaneous itemized deduction", and only reduce your taxes to the extent expenses in this category exceed 2% of your Adjusted Gross Income (line 37 on your 1040).


Consultant:
If you work as a consultant, the tax treatment is very different. You -- and the IRS -- will receive form 1099-misc from your "client" (not employer). Items on the 1099-misc are considered "self-employment income" and you still have to pay 15.3% of your pay in Social Security and Medicare taxes. Just as 1/2 of this amount is deductible by your employer when you are an employee, you are allowed to deduct 1/2 as an adjustment to income. Here's where the real difference comes in: unreimbursed-job-expenses are netted against your consulting income. This can result in a substantial reduction in taxable income for many people. Not surprisingly, the IRS would MUCH prefer companies to pay their workers as employees and not consultants.

The reason I'm writing about this topic now is that the IRS recently reached an important agreement with a soccer league in Connecticut regarding their treatment of coaches. Excerpt from $NYT article:

In a case widely watched by youth sports leagues across the country, the Internal Revenue Service has reached an agreement with the Fairfield United Soccer Association that clarifies the employment status of the group’s coaches, the association’s president said yesterday.

Under the agreement, the Fairfield, Conn., league will begin in 2008 to treat about half of its 30 coaches — those not employed by professional coaching associat ions — as employees rather than as independent contractors, and will withhold taxes from their pay. And the league will pay $11,600 in back taxes, according to Jay Skelton, the group’s president, a fraction of the $334,441 in taxes and fines the I.R.S. had assessed it in 2004.

“We said we tried to comply with the rules, and we thought we were, but we made mistakes, so we agreed to pay the tax due,” Mr. Skelton said. “For 20 years all of these coaches have been reported as 1099 employees for everybody. If you talk to 100 clubs, I guarantee almost every one, if not all, would declare these guys as independent contractors.”

It was not the first time the I.R.S. had fined a nonprofit youth sports league, but the proposed penalty was one of the largest, sending worried sports officials in Connecticut and other states scrambling to review the tax code. Mr. Skelton said that over the last two years, about 200 people involved in youth sports had contacted him asking about the resolution of the case. He said the assessment had threatened to put the Fairfield association out of business. (NYT)

The IRS wants the league to treat coaches as employees because the government will receive way more revenue that way. Here's a simple example to illustrate:

Coaches are considered "consultants" and issued 1099's:
Let's say a coach earns $1,000 in a year. The coach can easily cook up $500 of expenses related to the coaching job -- transportation, equipment, gifts, etc. The result is net self employment income of $500. This $500 is the amount which social security, medicare, & income taxes are based.

Coaches are considered "employees" and issued W2's:
Keeping with our above-mentioned example, let's say the coach earned a salary of $1,000 in a year. First, the employer & the employee would pay a total of 15.3% of the salary in payroll taxes. Second, the $1,000 salary would flow directly to the coach as "ordinary income". The $500 in job-related expenses are not allowed to be netted against this income. It is quite possible that the coach will not be able to deduct the $500 because he or she probably won't have miscellaneous expenses (including unreimbursed-job-expenses such as these) which exceed 2% of AGI.

Bottom Line: How you are classified -- employee or consultant -- makes a big difference for both you and your employer come tax season. Since the government wants you to be an employee (and not a consultant), it could become a little more difficult to keep your status as a consultant. Fortunately, there are some steps you can take to ensure that you keep your consultant status. I'll try to post about that topic soon.

Traditional or Roth 401(k)?

In 2005, Congress passed a law creating the Roth 401(k). What follows is an overview of 401(k) options as well as some thoughts to consider when figuring out which one is right for you.

How a regular 401(k) works:

Contributions to your 401(k) are pre-tax, meaning that the contribution amount reduces your taxable income. Any contributions that your employer makes do not count as income to you. At age 59 and a half, when you are able to start making withdrawals, you will pay tax on the distributions at your regular tax rate.

Example:

Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $85,000. This reduction in income results in is a substantial reduction in taxes – especially for those of us who live in high tax places such as NYC.

Retirement: Beginning at age 59 and a half, you start to take withdrawals from your 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will be counted as ordinary income and you will pay federal, state & local taxes on the full amount at whatever your tax rate happens to be at the time.

How a ROTH 401(k) works:

Contributions to your ROTH 401(k) are after-tax, meaning that the contribution amount does not reduce your taxable income. At age 59.5, when can start making withdrawals, you will not pay any tax at all on the distributions. By age 59.5, the majority of the money in your account will not be money you put in (principal) but it will be capital gains on the principal. Thus, you will be paying ZERO tax on the massive amount of capital gains and interest that will compound in your account over the next 40 years!

Example:

Current Year: You make $100,000 per year and contribute $15,500 to your 401(k) and your employer chips in another $5,000. Your taxable income for the year (from your employer) will be $100,000.

Note: unfortunately, the employer contribution has to go into a traditional 401(k), not the Roth 401(k)

Retirement: Beginning at age 59.5, you start to take withdrawals from your Roth 401(k). Let’s say you withdraw $100,000 per year. That $100,000 will not be counted as income and you will pay zero tax on the withdrawal.

Which should I choose – the Roth 401k or the regular 401k?

There is no simple answer here – it depends upon the individual and also your belief of what your future holds. Consider this hypothetical situation for Sarah & Jane. These gals have a lot in common: they are both 25 years old, earn $100,000 per year, and can contribute $15,500 to a retirement plan this year:

Sarah: Sarah has big-time career ambitions and plans to have a much higher income in the future. She loves to work and plans to do so, either for a company or herself, until at least age 75. She is an “aggressive saver” and already has substantial non-retirement assets. She loves New York City and plans to stay there forever. Also, she expects to get a substantial inheritance from her parents one day. It is very likely that Sarah will be in the highest tax bracket when she retires.

Jane: Today Jane has the same income level as Sarah but Jane has very different ambitions for her career. Jane plans to stop working at age 65 and live off of her 401(k) and perhaps a part-time job. It is unlikely she will have substantial assets outside of her house and 401(k). Given these circumstances it is likely that her tax bracket will be lower in retirement than it is now.

In this example, Sarah’s contribution to the Roth 401(k) will only be $11,250 (because of the $3,750 in taxes she will have to pay on the additional $15.5k in income.) Jane’s contribution into her retirement plan will be for the full $15,500. All other factors equal, Sarah and Jane will probably end up in roughly the same, after-tax position when all is said and done. This is because Jane’s higher contribution now, will result in a much higher future amount due to the miracle of compounding. However, since Jane will owe a bunch of tax on the future distributions, it probably evens out.

Of course, all other factors are never equal… Since Sarah is going to have substantial assets and income in retirement, her tax bracket will likely be very high. Also, it is quite probable that Sarah can afford to pay the $3,750 in additional taxes out-of-pocket and thus not reduce her current contribution at all. In other words, Sarah will contribute the full $15,500 into the Roth 401(k) – she will find the money somewhere to pay the tax.

If she does this for the next 40 years, Sarah will have $5.3 million (assuming a 9% CAGR) – all of which can be withdrawn completely tax free. If she invests in the traditional 401(k), she could owe 40%+ of this amount to the IRS!

Bottom-line: It is very clear to me that “aggressive savers” with high future earning potential should go with the Roth 401(k). For people not in this category, the answer isn’t so clear.

Follow these links for additional resources:

Bloomberg Calculator: Roth 401(k) or Traditional?
Wikipedia: Roth 401(k)
IRS Publication

Business or Hobby?

An article in today’s WSJ reminds me of an ongoing discussion I am having with a friend who has a website business. Recent legislation is making the distinction between business & hobbies a little grayer. The IRS published a fact sheet in April that is supposed to clarify the rules:

In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business…. Generally, an activity qualifies as a business expense if it is carried on with the reasonable expectation of earning a profit.

My friend’s website has reviews and commentary about dining and night life in New York City. For site content, he goes out and spends a lot of money on dining and night life. He wants to write-off all of these expenses on his Schedule C.

The site is actually very good – it contains detailed reviews for each restaurant and night club – and it is updated frequently. It has the prospect of making money because there are Google advertisements on the site.

Would the IRS consider this a business or a hobby?

Assuming everything is well documented, it would probably depend on whether this business has any prospect of ever turning a profit. The IRS will consider it a for-profit enterprise “if it makes a profit during at least three of the last five years, including the current year.”

I won’t venture a guess as to the likelihood this website will ever generate a profit, but the fact that he is trying really hard should be enough to allow the deductions on his Schedule C… at least for a few years. The main advice I gave my friend is that he’d better keep meticulous documentation of every single expense. Since he probably will get audited next year, the only way he stands a chance is if he can produce comprehensive books and records of his “business.”