Broker Check

Pre-Retirees Need to Plan Accordingly When Considering Part-Time Employment

by Darren L. Zagarola, CFP®, CPA, PFS

As published in the Princeton Patch, September 18, 2014

“To be or not to be,” said the almost retired, part-time employee,
“No,” said the independent contractor. “W-2 be or W-not-2 be,”
“So you’re an IC, I see,” said the part-time employee,
“On this,” said the independent contractor, “we can both certainly agree.”
“Good luck,” said the part-time employee, “with paying those taxes quarterly.”
“What quarterly taxes?” cried the IC. “My financial planner is going to kill me!”
“With an IC’s flexibility,” said the part-time employee, “You need to plan accordingly.”

Fakespeare, from his play, “A Mid-Summer Night’s Retirement Plan”

With apologies to Shakespeare, and perhaps Dr. Seuss, the independent contractor in the “sonnet” above didn’t plan accordingly, and in an attempt to hold off on drawing his pension and social security benefits, has actually gotten himself into hot water with the Internal Revenue Service (IRS). It’s an issue that many pre-retirees face as more and more take on part-time consulting work as a step before retirement. How they are classified -- employee or independent contractor -- will have major tax and financial planning implications.

Back in the day, retirement was more black and white. Someone worked until a certain age (typically 65 or 70) and retired, never to work another day again. Today, not so much. Many people are changing their belief of what retirement means to them. The definition has moved away from a 100 percent retirement -- i.e. ending their careers to live a life of leisure, of not luxury, on their pension, social security and life savings. However, for many baby boomers, retirement means moving toward the freedom to choose a work-life balance that is finally more focused on the “life” part, and working at a less structured level.

Aside from finally achieving the right balance of work and life, these baby boomers also realize that holding off on drawing their pensions and social security benefits will make these funds last longer into the future.

Retirees sometimes are offered the option to continue working after retirement for the same company as a consultant, or start a business themselves consulting for other companies within their industry or area of expertise. Individuals and companies both see the benefit of independent consultants. The question the retiree needs to address is whether it is better for them to be a W-2 employee or a 1099 independent contractor. There are benefits and drawbacks to each type of employment that a retiree should consider before making the decision.

W-2 and 1099 are tax forms for two different types of workers. Workers considered company employees are required to fill out a W-2 that helps determine the amount of taxes paid out. Employees are offered benefits, such as health insurance, sick and vacation pay, and 401(k) retirement plans, and are covered by non-discrimination laws. Employees are paid periodically through the company’s payroll system, similar to traditional, full-time employees. Half of the payroll tax is paid by the employer and the other half is paid by the employee through payroll deductions withheld automatically from their paychecks. The amount of withholdings depend on income level and range between 7.65% and 8.55% (6.2% Social Security, 1.45% Medicare Tax, plus .9% additional medical tax for individuals with earned income greater than $200,000 for an individual and $250,000 if married filing jointly). Employees typically work for one company and their job duties are controlled by others, unlike independent contractors. Employees are limited to the retirement savings opportunities available to them through the company.

Among the benefits of working as an independent contractor, filling out a 1099 tax form, is that they work for themselves. Contractors have the freedom to set their price and charge a fair market value fee for their services. They are required to invoice for their services and are paid through accounts payable, not through payroll. They determine for whom and when they work, and from where. They can work for multiple companies. They can work from home. They can have their own tools or equipment. Certain business expenses are deductible on their individual tax return. It’s important to note that they have the ability to save more for retirement than if they were an employee, depending on the individual retirement plan they initiate (IRA, SEP IRA, Solo 401(k)).

For independent contractors, the drawbacks include the unavailability of company benefits, such as healthcare. Independent contractors are responsible for calculating their taxes and paying them quarterly. They are responsible for paying both portions of the Social Security and Medicare Tax, although an IC can take a tax deduction of one half of the payroll tax (employer portion). The payroll tax increases to approximately 12 percent of their income. Other costs incurred by an independent contractor include the costs of establishing a Limited Liability Company and purchasing of liability and other insurances, although the IC has the ability to cover these costs in the rate they charge for their services. They should keep in mind that employers can save as much as 30-40 percent by hiring an IC versus an employee mostly due to not having to pay the employee benefits.

We issue two warnings for all those who will shortly be making the employee vs. independent contractor decision:

First, when deciding, do not fall into the trap of making the decision based on the larger take-home paycheck, which in most cases will be the IC route. Remember, ICs are responsible for their own taxes and retirement plan contributions.

Second, misclassification between the type of employment is a significant topic for the IRS. If you are misclassified, you could owe back taxes, interest and penalties. The main difference between independent contractors and employee is who is in control of the arrangement. If the consultant determines the scope of the work, when and how it will be done, most likely they would be considered an IC. An individual should speak with an employment attorney if they have any questions as to whether they are an employee or an independent contractor.