How does 1099 work? And what the difference is between a W2 employee and a 1099 contractor? Whether you’re an employee or an employer, it’s crucial to know how they differ especially when it comes to finances and tax season.
How Does 1099 Work?
It’s the employer’s responsibility to make sure their workforce is correctly classified. If they don’t, they could face a hefty fine – we’re talking up to millions of dollars. If hiring is handled internally, usually human resources is responsible for worker classification. But if employers are utilizing a staffing partner, the staffing company oversees the classification process.
Even though there are serious consequences for businesses who incorrectly classify workers, it can have an even bigger impact on the employee. If you don’t pay the correct amount when filing, you may be subject to additional fines.
But that’s not the most challenging aspect of being a contractor – it’s being able to answer the question, how does 1099 work? Below we’ll define the difference between W2 and 1099 employees and the risks associated with incorrect classification.
The Difference Between 1099 and W2
The best way to understand the difference between 1099 and W2 employees is knowing who the employer is in either situation. If you’re classified as W2, you’re an employee of the company you work for; they’re your employer. Under 1099 you’re an independent contractor (IC) and are technically self-employed; you’re your own employer.
Besides its definition, how to file taxes is the biggest difference between 1099 and W2 classifications. We’ll go into what filing looks like for each type of employee below.
Benefits + Risks Associated with 1099 Classification
Being self-employed is an attractive opportunity for some people. It affords the ability to be extremely flexible in both the work you’re doing and how often you do it. You have more control over your taxes and may have a higher earning potential. If you’re in a position where you work remotely or from home, being a 1099 employee might make more sense for you.
As a 1099 contractor, there’s no employer for you to pay federal, state, or local taxes to – meaning you receive the entirety of your paycheck. Sometimes people confuse this with the notion that they don’t have to pay taxes at all, which is incorrect. And can get you in big trouble with the IRS come tax time.
This means when filing your tax return, you need to account for the taxes that weren’t removed from your paycheck. According to ADP, “The self-employment tax rate is 15.3%, of which 12.4% goes to Social Security and 2.9% goes to Medicare. Income tax obligations vary based on net business profits and losses, among other factors.”
If you haven’t budgeted for taxes throughout the year, paying this sum at once can be challenging, which is why some prefer to have the taxes removed from each paycheck like when you’re a W2 employee.
There are additional (potential) risks associated with being an independent contractor that can come with serious consequences. These include:
- No workers compensation insurance.
- No ability to collect unemployment insurance (since it’s provided by the employer).
- No employee benefits (such as healthcare, PTO, etc.).
- Ineligible for sick time in states and municipalities with certain mandates.
If you’re an independent contractor who works on-site (as opposed to working at home), these potential risks could lead to a potential problem. If you’re injured at work, there’s no insurance to help with your medical bills. (Though you may have an opportunity for a lawsuit, but that’s a different conversation.) If you find yourself without work, you can’t collect unemployment insurance because it’s provided by your employer. The same goes for benefits, sick time, and PTO.
Another aspect to consider is that you don’t have any protection if you’re sued. This is especially worrisome for employees in industries that come with a higher risk of malpractice or accidents, like healthcare. Without the financial backing from your employer, could you handle the costs that may come with a workplace mistake?
Which Classification Makes You More Money?
Sometimes people agree to becoming independent contractors because they think they know how 1099 works and that they’ll make more money by not paying taxes up front. This is not the case. Under 1099, you’ll pay your tax return with a lump sum rather than paying in increments from your paycheck under W2.
Neither of these are necessarily better than the other; but if you’re paying the lump sum, be prepared to have that money available. If you don’t and have to pay your taxes past the due date, you may incur fines.
To better illustrate the difference between pay, here’s an example of what you’re paying as a W2 employee versus a 1099 employee:
W2 Employee (Single no dependents)
$15 an hour x 40 hours = $600 Gross weekly
$600 x 52 weeks = $31,200 yearly
- Federal Withholding – $44 weekly / $2,288 yearly
- Fica – $37 weekly / $1,924 yearly
- Medicare – $9 weekly / $468 yearly
Total Taxes withheld yearly – $4,680
Take home pay total after taxes – $26,520
1099 Employee (Single no dependents)
$15 an hour x 40 hours = $600 gross weekly
$600 x 52 weeks = $31,200 yearly
- No Federal taxes withheld*
- Fica Due at tax time – $3,573
- Medicare Due at tax time – $836
Total to pay in self-employment tax = $4,409 (Zero federal withholding to help cover that cost)
ACTUAL take home once taxes are paid = $26,791
*Note: W2 employees typically receive a return on their federal taxes. Since 1099 employees don’t have any federal taken out, they are not eligible to receive the return, meaning they may lose out on more money.
As you can see, both classifications essentially make the same amount of money; except the W2 employees can earn more with their federal tax return. So when everything is said and done, it seems like W2 employees get the better end of the deal. Even if their hourly rate is technically lower, the federal tax return makes up for the lower pay rate in the end.
Now that we can answer how does 1099 work and we understand the difference between W2 and 1099 classifications and how that can impact employees, let’s look at our key takeaways.
- If you’re working at a gig staffing company, there’s a 99% chance you need to be classified as a W2 employee. The most common industries and positions serviced by staffing companies have no reason to be 1099’d.
- If you’re classified as a 1099 employee, you won’t receive important coverage like unemployment insurance, workers comp insurance, and health benefits. Are you financially prepared to take on this cost if something were to happen?
- In the long run, you don’t save money by being a 1099 employee – you may even make more as W2 with your tax return.
If an employer or a staffing company is classifying you as a contractor, you need to answer “how does 1099 work?” and understand if this is appropriate for your position (or even legal). When deciding what classification is right for you, make sure you do the appropriate research, otherwise you could end up in a risky position.