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Understanding the Financial Implications of Independent Contracting

For over 72 million people working as independent contractors, either full-time or occasionally, understanding the financial implications is crucial. Independent contracting has grown significantly, with an 89% increase between 2020 and 2023, according to MBO Partners. But does it pay the same as a regular job? Let’s explore the key financial factors that can affect your income as an independent contractor.

Your Taxes May Be More Complex (and Expensive)

As an independent contractor, you are considered self-employed by the IRS, which means you will likely pay more in taxes compared to an employee earning the same hourly rate. You must pay self-employment taxes of 15.3%, covering Social Security and Medicare contributions. While deductible expenses like health insurance, office expenses, and retirement contributions can offset these taxes, you will need to meticulously track and document your income and expenses.

Additionally, if you owe more than $1,000 in taxes for the year, you must make quarterly estimated tax payments in April, June, September, and January to avoid penalties.

You Cover Your Own Expenses

While qualified business expenses are tax-deductible, you are responsible for covering a range of expenses, including setting up and maintaining a home office, health insurance, and more. Some of these costs may overlap with personal expenses, but others, like work equipment and additional utilities, are extra. It’s essential to consider these costs when setting your contracting rates.

Pay Can Be Unpredictable

The flexibility of independent contracting can lead to unpredictable income. Work may not always be steady, and clients can be slow to pay. Additionally, paid time off is non-existent. Budgeting with irregular income is crucial, and maintaining an emergency fund and a cushion in your checking account can help manage cash flow fluctuations.

Good credit can also be beneficial. Loans and credit can help smooth out income irregularities, but it’s important to avoid accumulating substantial debt. Regularly checking your credit and maintaining good credit habits can keep your borrowing options open and rates low.

Applying for Loans and Credit Is More Complicated

While being a contractor doesn’t directly affect your credit score, applying for loans or credit can be more challenging. You may need to provide additional documentation, such as tax returns, bank statements, and a current-year profit and loss statement, to show your earnings. If you’re new to contracting, you may not have a substantial track record to present to lenders or creditors.

Health Insurance Is on You

If you don’t have a job with benefits, you’ll need to use your contracting income to pay for health insurance. According to the 2023 Employer Health Benefits Survey by the Kaiser Family Foundation, the average annual premium for employer-sponsored health insurance is $8,435 for single coverage and $23,435 for family coverage. You may find lower-cost options through a government-run health insurance marketplace.

You Fund Your Own Retirement

As an independent contractor, you don’t have automatic retirement contributions or a 401(k) with employer matching. It’s essential to set up and contribute to your retirement plan. Options include traditional IRAs, Roth IRAs, and SEP IRAs. Even if you have a retirement plan at another job, maximizing your retirement savings through an IRA is advisable.

The Bottom Line

Earning money as a contractor is different from being an employee. Understanding the factors that affect your contracting income can help you evaluate opportunities, set prices, and manage your financial position effectively. As a contractor, you need to take a more active role in managing your money, including tracking income and expenses, keeping up with estimated taxes, paying for your own insurance, and making timely retirement contributions.

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