Working as an Independent Contractor

If you're in the software industry, you'll likely find yourself working as an independent contractor at some point. I've done this for my entire professional life with the exception of one seventeen month stint, and I like this side of the fence far more than I like the other side.

Here's a guide for making the most of it.

Standard Disclaimer: I'm not an accountant or a lawyer, and this should not be construed as financial or tax advice. Check with your own accountant and legal counsel before jumping into the world of independent contracting.

One of the biggest advantages of being an independent contractor is that you get to 'be your own boss' and work at home. This is one of the things I like the most: when the commute from bed to desk takes less time than the commute from bed to breakfast.

Herein lies one of the biggest problems to staying motivated: when you're at home, possibly in your pajamas, with distractions all around, it can be tough to focus on getting work done.

I strongly recommend that you setup a home office: a separate room, preferably with a door, where the work gets done. Put on real clothes in the morning, have a real breakfast, and then commute back upstairs to your home office and get to work. When you're done for the day, close the door and get back to the rest of your life. At least in my view, this work/life separation is critical to maintaining a long-term work-at-home lifestyle.

Another advantage of a home office? It's tax deductible. See below.

The second huge advantage of being an independent contractor is the tax benefits. If you're an IC, you're running your own business. That means you can deduct any legitimate business related expenses from your taxes. Need a new computer? It's tax deductible! Buying office supplies? Tax deductible. Driving somewhere? As long as you're going on business, the cost of the trip is tax deductible.

You file your business income on an IRS Schedule C, Profit or Loss From Business. You need to keep good records throughout the year to support your deductions. I recommend opening a separate business checking account, and then using a small business accounting program like Quickbooks Online or Outright to keep track of income and expenses. At the end of the year, it will be very easy to fill out your Schedule C.

A word on the home office deduction: if you have a home office, you can deduct the floorspace of the home office from your rent or mortgage payment. For example, if you have an office of 100sq ft in a 1000sq ft house, you could deduct 10% of your rent as your home office deduction.

As an employee, your employer will withhold taxes from your paycheck, which is probably one of the most genius systems ever invented by a tax collection agency. They typically withhold a little too much, which means you get a refund when you file your taxes. Imagine that… the government will give you money, and all you have to do is file this piece of paper by April 15!

As an independent contractor, you need to make sure that you make appropriate estimated tax payments. Your employer doesn't withhold anything (since you don't technically have an employer), which means you must remember to make payments. For most people, this means paying quarterly, on April 15th, June 15th, September 15th, and then January 15th of the following year. Typically, you need to pay 100% of your tax liability from the previous year. So if your final tax bill in 2009 was $10,000, you'd need to pay that much in 2010 ($2500 on April 15th, $2500 on June 15th, and so on). There are some exceptions to the rule; check with your accountant or read this TurboTax article.

Depending on your perspective, this estimated payment scheme can be good or bad. If you're savvy finacially, it's great: you get to keep your money for an extra few months rather than making an interest-free loan to Uncle Sam. But if you're not the responsible type, you will need to try extra-hard to make sure you make the payments, or else be stuck with a huge tax bill at the end of the year.

One of the biggest concerns for independent contractors is health care insurance. In the United States, your employer typically provides a plan for you, but as an independent contractor you obviously don't have access to such plans.

The difference may not be as big as you think; these days many employers are forcing their employees to pay an increasing large portion of the healthcare premiums, due to rising costs. Furthermore, the 2010 Obama Health Care plan will make it a lot easier and cheaper for independent contractors to obtain health insurance. Unfortunately, most of the provisions in that bill don't start until 2014.

In the meantime, there's still a good option. As Brian Hook outlines in a recent post, you can setup a Health Savings Account (HSA) combined with a High Deductible Health Plan (HDHP). A HSA is a special account which you put tax-free money into, and can then use to pay health expenses. The great thing about an HSA is that you can pay any health expenses with it: even a bottle of Tylenol can be purchased tax free. You complement the HSA with an HDHP: basically an 'emergency care' plan which pays for massive health care expenses, such as a car accident.

As an independent contractor, you can take advantage of many different retirement options. There's the standard IRA and Roth IRAs, but you can also take advantage of Solo 401Ks and Roth 401Ks, options that employees simply don't have.

Depending on your state and city, you may be required to get a business license if you're going to be an independent contractor. Check with your local Chamber of Commerce.