If you are paying more than 20 percent of your income in federal taxes, you are doing it wrong. That’s roughly what the Obamas pay every year — hey, at least it’s more than Mitt Romney. As you should know by now, Obama pays a lower real tax rate than his secretary, which is also true for Warren Buffett and most likely most affluent Americans. When you use an electronic product to compute your taxes, you always have the change to see your effective tax rate. If it’s higher than 20 percent, you should feel cheated, no? Particularly if you work for yourself, and your financial advisor has been warning you to put away 30 percent of all your earnings for taxes. In fact, Nancy Humphreys argues that self-employed people pay 25-43 percent tax rates!
(For a fun piece analyzing the IRS top 400 taxpayers, read this slightly dated post by tax truth-teller David Kay Johnston). Spoiler — one-quarter of the top 400 paid 15 percent or less in taxes).
This piece is not a whine, however: It’s a warning. Major changes are coming in the way Americans work, and pay taxes, and without sweeping reform, this new workforce is going to get crushed.
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The numbers are a little squishy, but the trend is not: Tens of millions of Americans will begin working for themselves during this decade. In a landmark report, Intuit guestimated that 40 percent of all U.S. workers will be classified as “contingent” workers by 2020. To you and me, that means freelancers — sole proprietors — or as I like to call them, onetrepreneurs. And they are going to have a hell of a shock once they start paying taxes, because it’s not unfair to say onetrepreneurs pay double the taxes of traditional corporate workers.
Some of this trend is the result of opportunities born of the Internet (I put myself and my BobSullivan.net adventure into this category). Costs of all kinds are down, and economies of scale once limited to large corporations — such as distribution of news — are now available to individuals. Hooray! This decade will see a surge in creativity among this group.
But that’s putting a brave face on it. The phrase “contingent workers” is really borne from the idea that many (U.S.) companies now enjoy the spoils of maintaining a flexible workforce. In other words, they don’t hire employees, they buy units of time, on an as-needed basis, from freelancers. In many cases, workers wish they had full-time positions and the benefits that come with them, but only piece work is available. It’s certainly not like the dock work doled out daily to longshoremen, as depicted in the movie On the Waterfront, but it can be a stressful way to earn a living.
Then, there’s the taxes.
For starters, contingent workers paid via 1099s must pay estimated taxes during the year. It’s the solo worker’s version of withholding. The IRS wants your money all year long, not just at the end of the year, so every quarter, freelancers must guess at their year’s tax liability and pay 25 percent to Uncle Sam. (The easiest way to do this is to set yourself up with an electronic account at the IRS. It’s a bit tedious, but worth it.) States (and city) tax rules vary, but that may be a separate quarterly pain.
Financial advisers tell freelances to set aside 30 cents of every dollar earned to make sure they have enough these quarterly payments. Wait: 30 percent? Why? Self-employment tax.
Anyone who’s ever received a 1099 report for extra income knows about self-employment tax, which can feel like double taxation. But with millions of folks entering these ranks, it can’t be repeated enough: When you work for any employer, that firm pays Social Security and Medicare taxes right along with you. When you work for yourself, you have to pay both halves of this tax, which can work out to about 15 percent. That’s 15 percent ABOVE your federal income tax rate.
One can certainly make the case that this is fair — each worker is responsible for contributing the same to these two services, which most people will receive benefits from at some point. I’m not arguing that self-employment tax is unfair here. But it is:
a) A shock, and will be a huge shock to contingent workers newly struggling to get by
b) A hassle and a burden, and a potential barrier to people who are considering the onetrepreneur life
If 40 percent of Americans are going to be freelancers by 2020, you don’t want to be in the 40th percentile. The sooner you embrace the onetrepreneur reality, and the quicker you beat other workers to the space, the better off you will be.
Congress and the White House could do a lot to make this embrace easier. Health care reform is a big step: Workers cite obtaining health care as a key barrier to starting their own small business. But tax reform is a close second. Making life easier for sole proprietors to pay their fair share of taxes would be a big help. My suggestions:
*Set up a withholding scheme that feels like traditional withholding for workers paid via 1099. Force companies that pay vendors to make withholding an option. This would “feel” much better than paying quarterly estimated taxes.
*Self-employment tax should be graduated so lower and middle class workers pay less. Right now, the scale is actually tipped in favor of the rich. Because Social Security and Medicare taxes are income capped, sole proprietors (or those who earn substantial salaries in addition to freelance income) sometimes end up avoiding self-employment tax at all because they have already reached the cap. That’s backwards.
*Self-employment tax could come with amnesty, or a ramp-up feature, to make things easier on folks who set out on their own for the first few years.
Some analysts predict a coming ”barbell economy,” with workers either sliding towards employment at huge corporations, like Walmart, or working for very small or solo companies. Few companies in the middle will remain.
Most of the good jobs will be on one side of that barbell, and I promise you, most of the innovation will be, too. If Congress wants to help the middle class and the future of America, it will consider reforming the self-employment tax — at least to make sure that contingent workers aren’t paying high tax rates than the president of the United States.
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