Monday, June 23, 2008

Employee versus independent contractor: marginal tax rates

I have a little side job. My boss said she wanted to reclassify me as an independent contractor instead of an employee. Is that OK with you? she asked. I said no problem. But I asked if the reclassification would affect my after-tax earnings. She said she didn't think so, but if I figured out that it definitely does, she could raise my wage accordingly.

So I went through the 1040 and schedule SE to figure it out. I put an X in for regular wages and a Y in for business income, and computed how each of X and Y would be taxed. I assumed that I would not be able to claim significant business deductions. The conclusion: my boss owes me a 9.3% wage increase (unless there are some legitimate business deductions that I could be claiming).

Excluding potential business deductions, the difference in marginal federal tax rates between the employed and self-employed ranges from 7.65% for low-income people, and may fall as low as 5% before disappearing altogether for income earned in excess of $97,500.

This difference arises from the fact that employers must pay half of the employee's social security and medicare (7.65%) taxes. In other words, the cost to an employer of "paying an employee $10,000" is actually $10,765.

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