Rich Girl Roundup: Got a W-2 and 1099? Check Out These Tax Tricks

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If you've got a W-2 job and earn 1099 income, there are some unique opportunities worth leveraging to lower your tax bill come April. We cover a few hacks to better save your hard-earned dollars.

Welcome back to #RichGirlRoundup, Money with Katie's weekly segment where Katie and MWK's Executive Producer Henah answer your burning money questions. Each month, we'll put out a call for questions on her Instagram (@moneywithkatie). New episodes every week.

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Transcript

Transcript

Henah:

How much would you say that you have saved or deferred via these two accounts away from your tax burden?

Katie:

Probably like $80,000.

Henah:

Oh my god. Damn.

Katie:

Welcome back Rich Girls and Boys to the Rich Girl Roundup weekly discussion of the Money with Katie Show. I'm your host as always, Katie Gatti Tassin, and every Monday morning, Henah and I dig into an interesting money discussion. Here is a quick message from the sponsors of this segment. Okay, so this week's upcoming main episode is about the history of the nine to five workday, if a four day workweek is a feasible option economically, and the issues of Americans not taking their vacation time. Onto the roundup. Henah, how are we doing today?

Henah:

I'm great. I'm excited for that episode because I think it was made for me, but this week's question is a case study of sorts and one I can also relate to. So the question is, how does having two sources of income affect your tax burden and is there a better way to optimize or minimize what you'll owe? So as usual, I'll throw in our disclaimer, we are not licensed financial professionals. This is not financial advice. Please do your own due diligence with a CFP or a CPA. This is just how we would approach it. So Katie, for our full-timers and side hustlers, myself included, how do you think about this?

Katie:

Okay, full-timers side hustlers gather round the fire. We'll casually refer to this often as the W2 and 1099 life because these are the tax forms that are typically associated with how your full-time income is reported and how your freelancer or side hustle or self-employment wages are reported. Now the key difference is that taxes are taken out of a W2 job typically, but usually not going to be taken out of the 1099 income. Although I guess I would add that in this remote work paradigm, there might be people listening that have two W2 sources of income or more than two W2 sources of income. Maybe they got three full-time. I mean, I don't know what y'all are working with, but for the sake of our discussion today, we are going to be kind of focusing on the pairing of the W2 and the 1099.

Henah:

You didn't know that our three W2 forms this year?

Katie:

It wouldn't surprise me.

Henah:

Oh, wow. That's kind of harsh. Okay, well I can test that I've gotten the huge tax bill that was partially impacted by having a side hustle that my taxes were not taken out of, but my CPA at the time eventually said that for future years I could consider paying quarterly taxes to be safe. So is that something that you would recommend for our 1099 folks?

Katie:

In my experience, maybe probably not. So there are a couple of things to think about here. The first is, I guess if you don't mind paying a tax bill in April and you're just concerned about penalties, you would want to know if enough of your income tax liability is being paid by the W2 income. You know how the IRS is they love the if this or this and that style, the logic statements that take a master's degree to understand, but the breakdown is you pay at least 90% of the tax that you owe for the current year or 100% of the tax you owed for the previous year, or you owe less than $1000 in tax after subtracting all your withholdings in credits or whatnot.

Henah:

I can tell that there's just going to be a, "But wait, there's more."

Katie:

There is more.

Henah:

As if it's not confusing enough.

Katie:

So I guess to recap, you have to be paying at least 90% of the tax you owe for the current year or 100% of the tax you owe for the previous year unless you make more than... if you're adjusted gross income on your previous year's return is over $150,000 or I guess 75k if you're married filing separately, you have to pay the lower of 90% of the tax shown on the current year's return or 110% of the tax shown on the return for the previous year. So for example, this year, I think in my W2 1099 situation, I'm not sure if we'll have paid 110% of last year's tax liability by the end of the year, but I'm pretty confident we'll have paid 90% of what we owe this year. So I think we should be in the clear again.

Henah:

Oh, I'm the opposite. The year that it happened to me, we had paid 110%, but we're not under the 90%. So those are the underpayment penalties that you would just have to pay come April or whenever you file your taxes for the year.

Katie:

So yes, you avoid a penalty if those things are true for you and as long as enough, "enough", whether that's calculated by the 100 or 110% of the year prior or 90% of the current year, as long as enough is being paid through your W2 wages, you won't face underpayment penalties. You'll just have to pay what you owe in April. But if you're really just trying to avoid having to settle up in April, you can always just increase your withholding at your W2 job. So more taxes withheld there and I would say that's probably easier than filing quarterly return separately because the IRS, they're looking at all the income that you're earning as just one big pot of money. So they don't really care if the taxes for the 1099 income is being paid out of the W2 job. They just want to make sure that overall you are paying what you owe.

Henah:

Gotcha. So maybe there's people who just want to plan for the tax season ahead of time. Flashback to me in November three years ago being like, "Wait taxes." So how does the self-employment tax work for those who are unfamiliar? Because it must be different obviously than if you are fully self-employed since this conversation is for people who have both a W2 and 1099.

Katie:

Yes and no. It's different for some people that have both.

Henah:

Oh, here we go.

Katie:

I remember when I was debating whether I should get an LLC and I had this idea that having an LLC was going to give me a bunch of tax breaks and then I was doing more research and I was like, "Wait a second, I have to pay another 15.3% on my self-employment income that goes through my LLC." I'm like, "Wait, this is just increasing my tax liability. This isn't helping me pay any less." But the TLDR is that if you look at your W2 income, if you were to look at your paycheck, you'll see the FICA payroll taxes line item and it's a 7.65% payroll tax that you owe and the funny part is that your employer also owes 7.65%. So you and your employer with your W2 income are basically splitting that liability. But if you're a 1099 worker, you are the employer and the employee, so guess what?

You owe the whole 15.3%. So that's what the self-employment tax is. 12.4 of it is social security and 2.9% of it is Medicare. So Medicare, there's no income above which Medicare tops out. You have to pay that 2.9% on your entire income, but social security has a top off point. So if you are W2 wages, and this is by person, not by couple, so each person has to pay up to 160k or so in income for social security, then if all of that is covered through your W2 wages, then your self-employment tax on any income above 160k is going to be drastically lower because you're just paying for the Medicare portion, but if you earn less, or let's say you make 100 in your W2 and then 60k in your 1099, you would owe the full 15.3% on that whole 60k. It's just like some people that have high incomes in their jobs end up paying for their entire social security liability.

Henah:

Gotcha. Okay. I don't know if you ever watched Friends, but Rachel goes and gets her first job after not having one as an adult and she gets her first paycheck and then she opens it and says, "Who the hell is FICA? Why is he stealing all of my money," and that's how I feel about this. Okay. So one thing you had recommended to me earlier to help minimize my tax burden was a solo 401k, but I think I needed an EIN to do that and I didn't know if I wanted to get into all that. So could you share how that might work and be beneficial for people who are ready to make that move and want to minimize their tax burden?

Katie:

Yeah, I'm not sure if this is how the IRS would describe it, but I think of an EIN number like a social security number for a business, and so typically this kind of goes hand in hand with establishing yourself as an LLC and registering your business. I guess you wouldn't technically have to, you can apply for an EIN number for free online, but it does sound from the reading that I've done that typically they recommend that you form an LLC before you get an EIN number. So something to consider, I think if you are serious about tax savings and you want to open a solo 401k, your tax savings in year one will probably more than cover the costs of your business formation. At least in my experience, it's very, very hard to open business checking accounts and business credit cards and impossible to open something like a solo 401k if you don't have an EIN number.

It's not against the law to use a business credit card if you do end up getting one without one, it's not against the law to put personal expenses on it, but it is against the terms of service for the card. So it's up to you how much of a risk you're willing to take with breaking the rules of the card member agreement. But yes, typically if you wanted to open a solo 401k, you're going to need an EIN and if you are going to be running this 1099 operation, you might just want to have one anyway. That way you can have separate accounts and stuff for that business income and you can kind of run it as like a separation of church and state from your personal side and your business side, and obviously if you have expenses against that business too, you want to be able to rank those off. If you're buying a computer or you have to outfit an office or you have to travel for your 10 99 work. There are a lot of things that kind of opens you up to, and it can be helpful to legitimize that.

Henah:

Good for the audience to know. So you built money with Katie, and then I think you said maybe when you started selling your wealth planner and you realized you were getting thousands of dollars in sales, you said, "Okay, I got to make this an LLC, protect myself, register," in I think the state of Delaware you said, so you then finally got your SEP IRA or a solo 401k or both? How did that work?

Katie:

Yeah. Well, I started with the SEP IRA because it was easier to open, did not require an EIN to back up a step. I wanted to get those accounts because I wanted to defer some of the business income that I was making and save and invest it for the future. It was money that I was going to invest anyway, so I was like, "How can I invest this in a way where it's also going to lower my tax burden?" So SEP IRA is how I started. Then I switched to a solo 401k because I felt like it gave me a little more flexibility. So the solo 401k rules, if you already have and contribute to a 401k at work, which is the situation that most people in this W2 1099 world are in, is they probably already have a 401k at their job that they're putting money into, the rules are a little tricky, so I'm going to do my best to not explain this in a way that's like professor with the elbow patches, eyes glazing over.

So the overall limit for your 401k contributions are based on source of income. So you can have 2 401Ks. One is for your 1099 work and one is at your job. So great, great. That opens us up to a lot. However, part of the complication is that that $22,500 elective employee deferral that we're all familiar with, that's by person, not by source of income. So you are only allowed to as an employee contribute that 22,500 in 2023 and I believe it's going up to 23,000 in 2024. You can only do that in one of these 401ks. And so typically what people will do is they'll max out their 401k at their W2 job as the employee, then they'll make employer contributions to their solo 401k, their 401k that's based on their business and employers can contribute up to 25%.

At the end, it ends up working out to around 20% of your net business income as the employer of yourself. And so when you're going through the solo 401k contribution flow, it'll ask you at least on Vanguard it does, are you making a contribution as an employee or as an employer? And it's very important that you choose employer if you are already maxing out your employee contributions at work. And the limit for 2023 is up to $66,000, I would work with the tax advisor, a CPA, someone like that to calculate the right amount for yourself if you're not comfortable doing the mental math that the IRS gives you, but that you could theoretically go, "Okay, I'm going to put in 22.5 at work as my elective employee deferral and then I'm going to turn around and oh, what do you know my business made 500k in net income. Yay. All right then I'm going to go ahead and put in all 66,000 in my solo 401k and it's all employer contributions and that would be totally fine."

Henah:

Girl, what are you doing with 500 grand and then you're still working at W2? Damn.

Katie:

Yeah, there you go.

Henah:

Okay, so that makes sense if you're covered at work. What if you are not covered at work?

Katie:

Yes. So if you're not covered at work, you could... This is where the solo 401k really shines I think over the SEP IRA that is because you could, I'm not going to say no matter how much your business is making, because it's not no matter how much you would need to be making at least as much as you're putting in, but you could make 50k in your 1099 and you could contribute 22,500 as the employee and then calculate your remaining 20% employer match for yourself, whatever, based on what's left over. So it allows you to put in more than if you had a SEP IRA.

Henah:

Gotcha. Okay. So then how does the SEP IRA work?

Katie:

The SEP IRA is basically someone that's already contributing, we'll say at their job to a 401k, for them, the SEP IRA and so 401k, no matter which one they pick, are going to kind of function the same way because both say you can put in 20% of your net business income as the employer. That's the only thing that you can do. The SEP IRA does not have this employee contribution option. So someone that doesn't have that 401k at work, someone that's only got their retirement account through their 1099 work, they are going to be able to put away a lot more with that solo 401k that's giving them that 22.5 employee elective deferral option.

The SEP IRA is just saying, "Yo, you can put in 20% of your net business income and if that's only $3,000 then it's only $3,000," right? You just get more room in the solo 401k if you don't have a 401k elsewhere. I would say just generally speaking, it kind of works the same way without the employee option. That's probably the easiest way to boil it down. There's no employee contribution option and they tend to be easier to open. They tend to require less paperwork. They don't need an EIN number, they're like a lower lift. You can get them at a robo-advisor. So it's kind of like the lower commitment option, but not without its drawbacks I would say.

Henah:

Can I add in caveat here? I believe we had spoken at one point about me doing this, but then it turned out if you had a SEP IRA, you couldn't then do a backdoor Roth conversion.

Katie:

Yeah. Yeah. So that is a great call out. The SEP IRA is considered a traditional IRA in the eyes of the IRS. They're looking at that they're going, that's an IRA with pre-tax money in it. And as we know about backdoor Roth IRAs, if you are doing a backdoor Roth IRA, you are making that conversion of post-tax dollars to Roth from a traditional to a Roth, you don't want a bunch of pre-tax money sitting around in an IRA because it's going to screw up the tax bill for you. So yes, I would say that is a consideration.

I guess though I would add that when it comes to income limits for Roth IRAs, remember that your income limit as a married couple, I think in 2023 it's 228k, but that's after contributions to things like 401ks. So if you're contributing 30k between you to 401ks and your income is 240 or 250 and then you're wiping off 30k in pretext contribution, you actually might not even need to do the backdoor Roth IRA. So that is something that I would highlight as depending on your situation, it might not be the end of the world, but it's absolutely something to be aware of if you are like a backdoor Roth IRA girly and that's part of your rich life, then be aware. Solo 401k does not have this issue because it's a 401k. I don't know why they care one way or the other.

Henah:

So if you had to put a number on it, Katie, how much would you say that you have saved or deferred via these two accounts away from your tax burden?

Katie:

Probably like $80,000.

Henah:

Oh my god.

Katie:

I've probably saved like 25 or $30,000 in taxes using these accounts over the last couple of years, which is obviously very significant.

Henah:

I mean, that's amazing.

Katie:

They're good tools. They're good tools for sure. Okay, well that is all for this week's Rich Girl Roundup. Obviously we can't cover the entire tax code in 25 minutes, but we tried, so we gave it the old college try and we'll see you on Wednesday to talk about the American work ethic and why people with PTO aren't taking it, which is actually probably going to be super relevant for people who are listening to this episode who have multiple jobs. Okay, bye.

Henah:

Bye.