How does 1099 work? And what the difference is between a W2 employee and a 1099 contractor? Whether youโre an employee or an employer, itโs crucial to know how they differ especially when it comes to finances and tax season.
How Does 1099 Work?
Itโs the employerโs responsibility to make sure their workforce is correctly classified. If they donโt, they could face a hefty fine โ weโre 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 donโt pay the correct amount when filing, you may be subject to additional fines.
But thatโs not the most challenging aspect of being a contractor โ itโs being able to answer the question, how does 1099 work? Below weโll 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 youโre classified as W2, youโre an employee of the company you work for; theyโre your employer. Under 1099 youโre an independent contractor (IC) and are technically self-employed; youโre your own employer.
Besides its definition, how to file taxes is the biggest difference between 1099 and W2 classifications. Weโll 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 youโre doing and how often you do it. You have more control over your taxes and may have a higher earning potential. If youโre in a position where you work remotely or from home, being a 1099 employee might make more sense for you.
As a 1099 contractor, thereโs no employer for you to pay federal, state, or local taxes to โ meaning you receive the entirety of your paycheck. Sometimes people confuse this with the notion that they donโt 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 werenโt removed from your paycheck. According to ADP, โThe 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.โ
If you havenโt 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 youโre 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 itโs provided by the employer).
- No employee benefits (such as healthcare, PTO, etc.).
- Ineligible for sick time in states and municipalities with certain mandates.
If youโre an independent contractor who works on-site (as opposed to working at home), these potential risks could lead to a potential problem. If youโre injured at work, thereโs no insurance to help with your medical bills. (Though you may have an opportunity for a lawsuit, but thatโs a different conversation.) If you find yourself without work, you canโt collect unemployment insurance because itโs provided by your employer. The same goes for benefits, sick time, and PTO.
Another aspect to consider is that you donโt have any protection if youโre 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 theyโll make more money by not paying taxes up front. This is not the case. Under 1099, youโll 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 youโre paying the lump sum, be prepared to have that money available. If you donโt and have to pay your taxes past the due date, you may incur fines.
To better illustrate the difference between pay, hereโs an example of what youโre 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 โ $44 weekly / $2,288 yearly
- Fica โ $37 weekly / $1,924 yearly
- Medicare โ $9 weekly / $468 yearly
Total Taxes withheld yearly โ $4,680
Take home pay total after taxes โ $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 โ $3,573
- Medicare Due at tax time โ $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 donโt 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.
Key Takeaways:
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, letโs look at our key takeaways.
- If youโre working at a gig staffing company, thereโs 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 1099โd.
- If youโre classified as a 1099 employee, you wonโt 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 donโt save money by being a 1099 employee โ 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 โhow does 1099 work?โ 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.
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Learn how businesses are impacted by misclassification here.
