Setting aside part of one's income to pay self-employment taxes is an area often overlooked by beginning freelancers. In fact, some freelancers mistakenly think that because they are self-employed they can avoid paying tax on their income.
Not so. The bottom line remains the same - if you have income, you owe the government. However, the definitions of employee, temporary worker, and freelancer are undergoing quite a bit of legal scrutiny these days. Why? Because the amount of taxes due, and who pays what part of the taxes, is largely determined by the category into which you fall.
Currently, taxes for a freelancer amount to almost 48% of gross income. One reason for this is because a self-employed person must pay his or her own share of withholding tax plus they pay the employer's share. To put this in perspective, imagine you have just landed a great contract. Your gross for the assignment will be $5,000. You have allocated 65 hours to do the work but you expect to finish sooner. Not bad! But before you spend that $5,000 on a vacation to Hawaii, you had better put aside $2,400 for taxes. Your net income for this job will only be $2,600. Better rethink that vacation trip!
As a self-employed worker, you have to charge a high enough fee to help offset these costs. If you are being paid $30/hour for an assignment, you will need to set aside $14.40/hour for taxes.
Does the IRS ever come down on employers or freelancers who break the rules? You bet they do. Consider the case of a major Texas publishing firm. The publisher claimed as a tax deduction the amount paid on 1099s to freelancer writers. During an audit, the IRS concluded that the freelancers were not paying withholding taxes on their income. The publisher was hit with a megabuck penalty; the freelancers were hit with penalties. Everyone had to pay the past due taxes plus penalties. (Now the publisher is paranoid about hiring freelancers; you must sign umpteen forms for the firm before they will hire your services. This is how I know about it. I had to sign the forms.)
I strongly urge both freelancers and prospective employers to read through the IRS guidelines that explain whether someone is an employee or a freelancer. I've summarized the main points in a separate post, but for a complete listing order your own copy from the IRS. To obtain your own copy of the IRS guidelines, call 800-829-3676 and ask for publication #15A.
My recommendation? Freelancers, set your rates high enough to cover your expenses. And pay your taxes!