In our previous article, we discussed W2 and 1099 incomes for physicians (and the red flags). Most doctors are going to take what we can get, but the ideal scenario tax-wise is to have both W2 and 1099 income. You can save a five-figure sum in FICA taxes in 2021 by having both forms of income, open up additional retirement contribution space, and enjoy some of the perks of being a self-employed 1099 contractor. You probably won’t shave off years to your working career by having both forms of income, but it sure doesn’t hurt.
FICA
To understand how the numbers hash out, we start with the FICA portion of Federal taxes. FICA comes from the Federal Insurance Contributions Act. The take-home message about FICA is that it includes Social Security and Medicare contributions.
Social Security is basically the government’s form of a pension. We pay into it during our working careers and hopefully will receive something in return when we retire. Medicare is our health system for the elderly, and our contributions will again fund the system so that it will hopefully benefit us when we qualify for Medicare benefits.
Social Security
Social Security (SS) contributions are split equally between the employee and the employer. In 2021, 6.2% of an employee’s income up to $142,800 is taken out to contribute to SS. The employer also pays 6.2% to the program (this does NOT come out of the employee’s income). A W2 employee only has to contribute her portion to the program. The Independent Contractor (IC) is both the employee and employer, so she would have to contribute both portions to SS.
For incomes exceeding $142,800, the SS portion of FICA goes away. During our working years it sounds good that Uncle Sam has a ceiling to how much he’ll take from us, but this also means that there is a ceiling to how much Social Security benefit you’re going to receive in retirement.
Don’t count on SS bankrolling your retirement.
Medicare Tax
Unlike SS Tax, there is no income ceiling for Medicare Tax. Employees pay 1.45% of their incomes towards Medicare while the employer also contributes 1.45%. Again, the IC physician pays both portions while the W2 employee only contributes her share.
For single filers, the employee portion of the Medicare Tax increases to 2.35% after an income of $200,000 ($250,000 for joint filers). Consider this additional tax on making more money a way to even out the system.
Medicare Tax Example
Suppose your W2 income is $142,800, and your IC income is $100,000. Your stay-at-home husband has no taxable income. Your W2 employer has effectively paid your SS taxes in full, so none of the IC income is subject to SS tax. You save roughly $17,000 in taxes. Not bad.
You can’t escape the Medicare Tax that everyone incurs if you pay your IC taxes as a sole proprietor, but if you do earn enough consistently you could consider opting to be taxed via an S-corporation. Businesses frequently opt for this route as a means to reduce the amount of tax paid to Medicare, but there is more administration involved. For IC physicians who anticipate receiving consistently high income annually, it can be worthwhile to make the switch.
Maximize your retirement savings
Saving on SS taxes is great, but you can open a SEP-IRA or Individual 401k retirement account to supercharge your pretax retirement savings. While a SEP-IRA is technically easier to open, I recommend opening an Individual 401k so that you can keep your IRA basis zero in order to fund a backdoor Roth IRA every year.
The contribution limits on a 401k is $58,000 (without catch-up contributions) in 2021. Of the $58,000, $19,500 constitutes the employee contribution. You can contribute the employee portion through either you W2 job or your IC job, not both. Most people would choose the one for simplicity or with better benefits. The maximum employer contribution is 20% of your net profits.
Individual 401k Example
Here is a simple example:
- W2 Income: $150,000
- IC Income (net): $100,000
- Contribute $19,500 to the W2 401k.
- Contribute $20,000 to the employer portion of the Individual 401k.
So effectively you’ve contributed $39,500 to your pretax retirement in two accounts. Not bad.
Considerations for the tax-adverse
If I had the choice, I’d rather be burdened with more taxes rather than not taxed at all (no sneaky tax reduction strategies either!). Tax burden means that you’re actively making money.
In our exercise of learning about FICA, we realize that this is exactly why two-income households where one spouse earns significantly less than the other is a tricky process.
The lower-earning spouse not only incurs the base SS Tax of 6.2% on her earned income (12.4% for self-employed), he also is taxed at the marginal tax rate of the combined households. So if the primary spouse earns $650,000 as a busy EP cardiologist, her husband who earns $30,000 from self-employed website design income will give up 37% to federal taxes, 12.4% to SS Tax, 2.9% to Medicare Tax, and another 0.9% as a high earner for Medicare! This is 53.2% before any state taxes! He’d better just put the bulk of his income towards his 401k instead.
Maximize your savings by combining W2 and 1099 income
The moral of this exercise is that if you have the opportunity to combine both W2 and IC 1099 income, you can save a bit more towards retirement than if you earned the same amount through one income stream alone. Not everyone will have that opportunity, but you can certainly make the system work for you.
If you haven’t read our first segment on W2 and IC income and their red flags, head back over to read it!
How have you obtained W2 and IC income?
Note that none of the content discussed in this article construes medical or legal advice. The content is only to be used for entertainment purposes only. If you have medical or legal questions pertaining to your job, please consult a licensed professional in the topic of concern.