A freelance consultant earns $80,000 in 1099 income. A salaried employee earns $80,000 in W-2 income. Ignoring deductions, who faces a higher total federal tax burden on the same gross income?
AThe W-2 employee — withholding spreads the tax burden and increases the total owed
BThey face equal burdens — both earn the same gross income and pay the same income tax rates
CThe freelancer — self-employed workers pay the full 15.3% self-employment tax in addition to income tax, while W-2 employees pay only 7.65%
DThe W-2 employee — employer-paid payroll taxes are included in the employee's taxable income
This is the key misconception about self-employment. W-2 employees split payroll tax with their employer — the employee pays 7.65% (for Social Security and Medicare) and the employer pays another 7.65%. Self-employed workers effectively pay both halves: 15.3% in self-employment tax, on top of ordinary income tax. On the same $80,000 gross, the freelancer owes roughly $12,000 more in payroll taxes than the W-2 employee. (Half of self-employment tax is deductible, partially offsetting this, but the net burden remains higher.)
Question 2 Multiple Choice
An investor sells stock she held for 18 months at a $10,000 profit. Compared to earning the same $10,000 as wages, how is this taxed?
AThe same — all income is taxed at the same ordinary income tax rates
BAt a higher rate — investment gains face an additional capital gains surcharge on top of income tax
CAt a lower rate — long-term capital gains are taxed at preferential rates of 0%, 15%, or 20%
DTax-free — investment income from assets held more than one year is exempt from federal tax
Long-term capital gains (from assets held more than one year) are taxed at preferential rates — 0%, 15%, or 20% depending on total income — substantially lower than ordinary income tax rates, which can reach 37%. The 18-month holding period qualifies this as long-term. This is why a wealthy investor may pay a lower effective tax rate than a salaried employee: much of their income is classified as long-term capital gains. Short-term gains (held one year or less) are taxed as ordinary income.
Question 3 True / False
Self-employment income is generally less burdened by tax than W-2 wage income because freelancers can deduct their business expenses.
TTrue
FFalse
Answer: False
While business deductions do reduce a freelancer's taxable income, the self-employment tax (15.3% on net earnings, covering both employee and employer shares of Social Security and Medicare) creates a significantly higher baseline tax burden than W-2 employment. A W-2 employee's employer pays half of payroll taxes — a benefit the freelancer doesn't receive. Business deductions can offset this partially, but on the same gross income with similar expenses, the freelancer's total tax obligation typically exceeds the W-2 employee's.
Question 4 True / False
Long-term capital gains from investments held more than one year are taxed at lower rates than ordinary wage income for most taxpayers.
TTrue
FFalse
Answer: True
Long-term capital gains receive preferential tax treatment: rates of 0%, 15%, or 20% depending on income bracket, compared to ordinary income rates that rise up to 37%. This is a deliberate policy choice intended to encourage long-term investment. The practical effect is that an investor earning $100,000 in long-term capital gains may pay less federal income tax than a worker earning the same $100,000 in wages.
Question 5 Short Answer
Explain why a freelancer and a salaried employee both reporting $80,000 in gross income do not face the same total federal tax burden, focusing specifically on how payroll taxes differ.
Think about your answer, then reveal below.
Model answer: W-2 employees and their employers each pay 7.65% of wages in payroll taxes (Social Security and Medicare), for a combined total of 15.3%. The employee only sees and pays their 7.65% share — the employer's share is a separate cost that never appears on the employee's paycheck. A self-employed worker must pay both halves themselves as self-employment tax: 15.3% on net self-employment income. On $80,000, the freelancer owes roughly $11,300 in self-employment tax, while the W-2 employee pays about $6,120. Although self-employed workers can deduct half of self-employment tax from gross income (reducing the income tax portion), the net payroll tax burden on a self-employed person is substantially higher than on a W-2 employee with the same gross income.
This asymmetry is one of the most important practical insights in personal taxation. Many new freelancers are surprised when their first tax bill arrives — they saw the full payment from clients and didn't realize that a large portion was effectively payroll tax that an employer had been quietly paying on their behalf in their previous job.