Being an independent contractor: Understanding the taxes (Part 1)

You finally accept your first job at a great private practice. They offer you $600 a day (about $150,000 a year), and you are ecstatic. You remember them saying something about being an independent contractor, but you didn’t really understand what that meant, so you took the job anyway. Now you are left to figure out what that means.

One of the most likely scenarios that’ll ruin a dental grad’s finances is securing your first job as an independent contractor and not understanding the tax consequences. In this post, I’ll give you a general idea of how this could happen and some action steps to prevent an unexpected tax bill.

Most of the time, new grads will be hired as employees. This is usually the case with corporate positions, the occasional exception being with specialists. There are times, though, when new grads find their first job as an independent contractor. What does this mean?

1. You’re a business owner. You are now a sole proprietor (or a corporation, which I’ll cover in another blog post). You may need to get a business license. Your $150,000 a year is more like “gross revenue” than it is “income.” You are responsible for everything that goes on in your business including paying taxes, having proper licensing, etc.
2. You can deduct certain business expenses. Since your $150,000 is more like business revenue, it isn’t taxed until after your business expenses. These expenses can be things such as licensing fees, tax and legal fees, equipment purchases, certain insurance costs, etc. If you were an employee who was making $150,000 a year, you would have to pay income taxes on the whole amount. We’ll assume you have $15,000 in business expenses (it’s tough to justify much more that), which means that you will pay taxes on $135,000.
3. You are responsible for paying taxes. And not just income taxes but also payroll taxes and any other tax your local, state or federal government decides to impose on you. Income taxes typically need to be paid quarterly.

Here’s an example of how this might work.

You make $150,000 your first full year out of dental school. You managed to incur $15,000 in business expenses and are left with a taxable income of $135,000. We will also assume you are in California, which has a high state income tax, and that you are single with no dependents. You will reach the 28 percent federal tax bracket, but because you start out in a lower bracket, your effective tax rate (meaning the actual percentage of your income that went to taxes) will be around 20 percent. For California, the marginal rate would be 9.3 percent with an effective rate of about 7 percent. So you are up to 27 percent of your income going to the government.

The tax that many people forget about is self-employment tax, also known as FICA and Medicare, or payroll tax. If you were an employee, you would pay 7.65 percent and your employer would pay 7.65 percent (which is one reason why many private practice owners prefer to have independent contractors — they don’t have to pay this).

Since you are the “business,” you pay a total of 15.3 percent (12.4 percent for FICA and 2.9 percent for Medicare). Your tax bill is now 42.3 percent (20% + 7% + 15.3%) on your first $127,200 of income, and 29.9 percent thereafter (FICA is only charged on the first $127,200, called the “social security wage base” and can change from year to year). So your tax bill would be roughly $56,000. Sorry for the bad news.

Of course, this is just an example and purely hypothetical. Things such as having dependents could change these numbers. The tax bill could be overstated, as some of the payroll tax is deductible, and you might have other deductions that could reduce your tax bill. Also, I don’t practice accounting, so please make sure you discuss your specific situation with a certified public accountant when it comes to doing your taxes.

In my next post, we’ll be discuss setting up a corporation, designing your own benefits and tips for managing your “business.”

~Ryan Schulte, financial advisor

Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS).OSJ: 4275 Executive Square #800 La Jolla, CA 92037. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. WestPac Wealth Partners, LLC is not an affiliate or subsidiary of PAS or Guardian. CA Insurance Lic. #0F03557 | Guardian and its subsidiaries do not endorse or have any direct or indirect responsibility with respect to this activity | This material contains the current opinions of Ryan Schulte but not necessarily those of Guardian or its subsidiaries and such opinions are subject to change without notice.

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