Adding income is a great way to improve your financial situation. And working as an independent contractor is a popular option for military spouses. Many independent contractor job, which report earnings on a 1099 instead of a W-2, are flexible and portable, making them ideal for military spouses. I worry, however, that military spouses don't always consider the full tax implications of their jobs when considering if their time is worth the money that they're making.
I just spent my morning with my accountant, geeking out about various tax laws and finally finishing my family's 2016 tax return, and taking at look at what our 2017 return might net. For a variety of different reasons, this is the year where I really started to wonder whether my working is worth it.
When Working Doesn't Pay
Regardless of how you're paid, there are times when your job just isn't worth the money you're making. This is particularly true if you're paying for childcare, but there are other expenses of working: income taxes, clothes to wear to work, commuting expenses, haircuts and other personal grooming, hiring help for jobs you don't have time to do, meals purchased while working, office gifts or other semi-mandatory fun, and did I mention taxes?
Most income is subject to employment taxes, where both the employer and employee each pay 7.65%. This is separate from the federal and state income taxes you'll pay, which can range from none to over 50%. Most people pay a total federal and state tax amount somewhere between 10% and 35%, depending on their taxable income and their state's income tax rates. While numbers are all over the place, the average combined federal and state tax rate is around 23.4%. (13.5% average federal taxes, 9.95% average state and local taxes.) Add in the employee's portion of employment taxes, and regular, W-2 reporting jobs have an average tax rate of around 30%.
The Unique Problem With Self-Employment
Self-employment eliminates or changes many of the expenses of working. You may not have commuting costs, and you may be able to work in your PJs. You may be able to deduct certain expenses. But you'll also bear the full-brunt of employment taxes, paying both the employer and employee portion. This means that your average self-employment tax rate is over 37%.
Moving Into The Edge Zone
Averages are interesting, but they don't really mean anything to the individual taxpayer. What matters is your specific tax rate. If you're not paying any taxes, then the value of your self-employment income isn't diminished by taxes. But move up the tax scales, or start losing some credits or deductions as the result of your additional income, and you may legitimately start wondering if it pays to work. But you don't have to be in a high tax bracket to be negatively impacted by the taxes on your work.
Let's take the case of my friend Katie. (Katie's not a real person, but a composite of several folks with whom I've worked and spoken.) A teacher, she was able to score a coveted job teaching online. She makes a $16 per hour, working 10 hours per week, and it seems like the perfect job. A little closer inspection shows that she's not making as much as it seems.
First, we apply the 15.3% self-employment taxes, equaling $2.45 per hour. Then, her family is in the 10% federal tax bracket. Since Katie's income is "last," they're paying the full 10% tax on her income, equaling $1.60 per hour. Katie is a resident of Virginia, and she pays 5.75% state income tax, reducing her hourly wage another $.92 per hour, for a total-percentage based tax cost of $5.77 per hour. Now Katie's only just over $11 per hour. But she's still bringing home $440 per month, and it's a big boon to her family's overall financial situation.
Here's where things get really surprising. Katie's $8,000 gross income, which is really only about $5,500 after regular income taxes, reduces their Earned Income Tax Credit from over $1400 per year to less than $200 per year, a loss of over $1200. And, they moved from the 50% to the 20% credit of the Retirement Savings Contribution Credit, losing another $600 credit each year.
All in all, Katie's $8,000 yearly income is netting around $3,480 for the year. That's still great, but it's nowhere near what Katie expected she was making. Once you consider all the taxes on her income, and the loss of those credits, this amazing job is a little less amazing. And we haven't even gotten to the worst part.
To Withhold, or Not To Withhold
Here's the real problem with those 1099 job: the company paying you not withholding any of these taxes that will be owed on the income. In a regular W-2 job, your employer withholds the half of the employment taxes you're paying, plus they withhold for regular income taxes. This can be a big surprise come tax time.
Using our same example, let's imagine that Katie's spouse is withholding the right amount of taxes from his or her job, so they don't typically receive a large refund, and they integrate Katie's entire income into their monthly budget. That's the whole purpose of getting a job, right, to have money to use for paying off debt, extra spending, retirement savings, or even just a really cool trip!
Except that Katie is going to owe that $4,320 to the IRS when they file their federal income tax return.
Now, if her spouse has been overwithholding, and they typically receive a big income tax refund, perhaps they just don't get that big income tax refund. Either way, it's going to be a big hit at one time.
The only way to "solve" this problem is to put money aside from every paycheck, and make quarterly estimated tax payments to the IRS. It's like DIY withholding. It works, but only if you do it. And unless you're a tax professional, it can be hard to estimate how much to save.
Obviously, every family has different details. Katie's exact situation may or may not unfold in real life, though I've made it pretty darn close using multiple tools. The actual impact of taxes on your take-home pay may be more, or it may be less, depending on all the other things happening in your tax world. But yours truly just had an eye-opening morning when my accountant and I drilled down the numbers, and figured out that my pay is increasing our family's taxes by more than 30% of what I make, plus there are a couple of other second- and third-order consequences, such as the impact of my income on my children's need-based financial aid for college.
The point of this article isn't to say, "Look, you're making half of what you think." Sometimes it is true, sometimes it's not true. As always, my goal is present concepts and information for you to think about and apply to your situation. If this sounds like a lot of mumbo-jumbo, seek out a tax-savvy friend, an accountant, or stop by the Personal Financial Specialist office at your base family readiness center for some education and understanding. Only then can you make an educated choice about whether the money you are bringing home provides value for the time you are swapping.
