Learn More About Income Tax Basics for the Gig Economy

We live in the post-recession economy. Along with more skepticism over the future of the economy, many have bought into the gig economy—where people take individual contract jobs rather than working for a larger company. Some might call it the American dream but if you don’t plan correctly, it could turn into something of a nightmare.

The Facts

A study by authors from Princeton and Harvard Universities found that the number of freelancers grew from 10.1% in February of 2005 to 15.8% in late 2015. Computer jobs hold the most freelancers but customer service, medical, and writing industries attract many as well. Freelancers beware—you might be setting yourself up for financial turmoil if you don’t think of yourself as a business owner. It has to do with taxes.

Taxes

As a freelancer you have to pay taxes just as you would if you worked for a larger company but with one important caveat. You’re responsible for all of the taxes. What you may not know is that when you are an employee, your employer pays half of your total Social Security and Medicare taxes. Thus, as an employee of someone else’s business, you paid 6.2% of your salary (up to the taxable maximum) for Social Security tax, and a 1.45% Medicare tax, (combined total, 7.65%.) Your employer was required to match those payments. Thus, your total contribution for Social Security and Medicare (your payment plus the employer’s) was 15.3%. And, of course, you also had money withheld from your paycheck for income taxes calculated based on the information you provided your employer on a W-4 form. As a freelancer, you have to pay both parts of the Social Security and Medicare taxes. Instead of paying the government your income tax plus 7.65% (combined Social Security and Medicare tax), you pay income tax plus 15.3% (minus any deductions or credits) That 15.3% is called a self-employment tax.

Determining the total amount of income tax, Social Security and Medicare taxes you’ll owe for the year isn’t easy. You have to take into account your income, your tax bracket, deductions, and credits. If your business is relatively stable, simply look at last year’s tax return and take numbers from there. Or, a very rough estimate is to take 35% of every dollar you make, put it in a separate account and use it to pay taxes. If you are required to pay state and city income taxes, don’t forget to calculate their cost for the year, too.