Retiring early vs. doing project work
Independent contractors enjoy great freedom and flexibility, but make sure you understand what the IRS expects from you.
By Anne Fisher, FORTUNE senior writer

(FORTUNE) -- Dear Annie: I've been a marketing manager at a FORTUNE 500 company for 25 years and would like to take early retirement. (I'm 55 and have managed to put aside a pretty good-sized nest egg.)

My employer, however, doesn't want me to leave yet and suggested a compromise whereby I would continue to work for the company on a project basis and would be paid as an independent contractor.

My hours would be much more flexible, which would be great, and my boss (who would still be my boss under the new arrangement) says I could even take a month or two off between projects. It sounds like the perfect plan, but can you see any hidden pitfalls here? -Cautious in Cleveland

Dear Cautious: You're smart to ask. The number of people in the U.S. working as independent contractors rose by almost 9% last year, to just over 12 million, according to the American Staffing Association, and the Department of Labor expects a further 150% increase in the so-called contingent workforce by the year 2012.

Yet many experts say that about half of the folks who call themselves independent contractors don't conform to the IRS definition of the term, and that poses a big risk: Once you start filing tax returns as a 1099 worker - as opposed to a regular full-time W-2 type - you're far more likely to be audited and, if you haven't followed all the rules, to owe a big tax bill.

How can you avoid that fate? Andrew Schultz, president of PrO Unlimited, a global consulting firm that advises companies on how to make the best use of contingent workers, has four basic tips for you.

1. Understand that you will be a separate business. "You need to get your own insurance, because you and your work will no longer be covered by your employer's," Schultz says. "At the very least you need general liability insurance. Tech contractors may also want to consider errors and omissions insurance."

You also need to set up a home office and use it as your primary place of business. If your employer wants to set you up with an office on its premises (maybe even the same office you're occupying now), say no.

2. In order to satisfy the IRS (and many state tax authorities) that you are a true independent contractor, be ready to get paid on a project-by-project basis, rather than weekly or monthly.

"A true independent contractor is remunerated for producing a given result, not based on - in the IRS's phrase - 'the passage of time,' " Schultz says. "For many people, this can be hard to get used to, because it's very different from having a regular paycheck."

3. You'll have to start paying 100% of your own payroll taxes. Your employer now pays half of your Social Security tax, for instance, but will not be allowed to do that in the future. And you must file tax returns every quarter.

"Factor in the cost of a good accountant, who will also be able to advise you on what you can write off and what you can't," says Schultz. "In absolute dollar terms, independent contractors often make more money than regular employees, but they also have these hidden costs."

4. You need more than one client. This is where you may really run into a problem: If your only customer is your former employer, then by the tax people's lights, you're not really an independent contractor but rather an employee in disguise. So, before you agree to this new deal, think about whether you can take on at least one other client, and preferably two or more.

Why all the red tape? "The IRS says it is aware of $100 billion in missing tax revenues, most of it attributable to people who claim to be independent contractors, because 1099 workers are believed to underreport their income and exaggerate their expenses," Schultz says. "So calling yourself an independent contractor is a 'red flag' to auditors - to the point where, for many people, meeting all the requirements is just not worth the trouble."

You might, in other words, be far better off keeping your current job a while longer, or retiring altogether.

-------------------------------------------

Related: Best Places to Retire Top of page