Why do I owe so much? The curse of the independent contractor.

A common difficulty that many people doing independent work run into is the hefty tax bill due at the end of the year. Many people whose primary source of income is from their own business (including full-time contractors) are prepared for this and make the proper allowances and estimated tax payments during the year. But others who are just starting out, or who do some independent work on the side of their full-time (or part-time) job can often be shocked at the balance due to the IRS and state tax agencies. For example, it's not uncommon for a $5,000 (net profit) job to incur a total tax liability of $2,000 or more. Why?

Often people think of taxes as a monolithic thing that is applied in one lump sum against their earnings, but to understand why independent contractors often feel like they're getting a raw deal, it's worth splitting out the total tax charge into three component parts.

First, and foremost, there are Federal Insurance Contributions Act (FICA) taxes, better known as Social Security and Medicare taxes. They're also often known for workers as payroll taxes, and for contractors/businesses as self-employment taxes. These taxes are assessed at a flat rate of 15.3% for every dollar earned up until the cap, which currently sits at $127,200. (If you're interested, 12.4% goes to Social Security, and 2.9% goes to Medicare.)

These taxes are often invisible to employees because they're withheld automatically from paychecks. And quite importantly in a nominal sense, employees only have half of those taxes deducted from their pay. So for each $5,000 in gross earnings that you have as an employee, you'd only see a little more than $375 deducted from your paycheck. The other $375 is paid directly by your employer, without appearing on your pay stub. Economists would want me to note that despite the fact that employers actually write the check for the tax, the real effect of the other half of the tax is that the employees' wages are held down, so the tax incidence or burden falls entirely on the employee.

Contractors, small business owners, and other self-employed people, shoulder the full burden of both halves of the FICA taxes, explicitly. For each $5000 they earn, they can expect a little more than $750 in FICA taxes, before any income taxes are assessed.

Secondly, our federal income tax rates in the United States are progressive. That means that the more that you earn, the higher your rate. It doesn't mean that a single dollar (or even hundreds or thousands of dollars) of additional income can change the tax rate for all your income. Everyone pays the applicable rate for each band of income. So everyone pays the lowest rate (10%) on their first $9,325 in taxable income, the second lowest rate (15%) on their next $28,625 in taxable income. After $37,950 in taxable income, the applicable federal rate is 25% or higher. So if you have a job that pays you a middle-class income of somewhere over $50,000, and then do a $5,000 contracting job, the federal income taxes on your $5,000 will come to at least $1,250.

So just between FICA taxes and federal income taxes, contractors are paying over 40% as their marginal tax rate. That's more than $2,000 on that $5,000 in income for helping design a website, writing a report, providing consulting services, or whatever income-producing activity you may have done on the side that you received a 1099-MISC for. 

And that's without even considering the third piece in our puzzle: State taxes. States tax rates are highly variable between states and even within states. Most states have a progressive tax scheme like the federal government, but the level of progressivity varies. But it's not unfair to generalize to a rate of 5-6% at middle income levels. (For example, at $50,000 in income, the DC rate is 6.5%, the VA rate is 5.75%, the MD rate is 5%, the NY rate is 6.45%.) That's another $250-$300 in taxes on your $5,000 in income.