The 2016 tax filing deadline is now just one month away. Which makes it timely to point out how unfair our tax system is to middle class workers who want to prepare for their retirements. It is also timely to explain how there is a completely different set of retirement rules, far more favorable, that apply to unionized government workers.

If you are a member of the emerging “gig economy,” or a sole proprietor running a small business, or an independent contractor, and if you are reasonably successful, then you paying nearly 50% of every extra dollar you earn in taxes. The following table shows the marginal tax burden for independent contractors who earned more than $81.5K and less than $118.5K in 2015:

Marginal Tax Rate for Independent Contractors
(for 2015 earnings > $81.5K and < $118.5K)

20160301-UW-ER-TaxRates

The challenges posed by this reality bear closer examination. Let’s say, for example, that someone in this category needs to earn more money, and they have an opportunity to earn a few extra bucks by taking on a side project. For these earnings, they will pay 25% federal, 8% state, 12.4% Social Security (as employee and employer), and 2.9% Medicare. And by the way, the employee’s portion of their Social Security contribution is NOT tax deductible. What if they decide to put that money into a 401K?

According to current tax law, private sector taxpayers can only defer up to $18,000 of their income into a 401K, up to $24,000 if they are over the age of 50. Contrast this to the unionized public employee’s pension fund.

If the payments into a public employee’s retirement account exceed $24,000 per year – which they usually do – they remain tax deferred. A California Policy Center study (ref. table 4) examining 2011 compensation for City of San Jose employees showed that the average employer contribution for a police officer’s pension (not even including whatever they may have also contributed via withholding) was $53,222 in 2011, more than twice the amount they would have been able to avoid paying taxes on if they were private citizens. For San Jose firefighters it was even more, their average employer pension contribution was $62,330 in 2011. And even for the miscellaneous employees, the city’s contribution exceeded the tax deferred amount allowed private citizens, averaging $26,164 – again, not including whatever pension contributions these employees may have paid themselves through withholding. San Jose’s case is typical.

So why aren’t public employees paying taxes on whatever annual pension contribution they make in excess of $18,000, or $24,000, depending on their age? Because there is NO practical limit on how much can be contributed into a defined benefit plan while still avoiding taxes. The IRS created the limit on how much you can put into a 401K in order to discourage people creating “abusive tax shelters.” But they did not apply this moral standard to defined benefit pensions.

Meanwhile, there’s not only a ceiling on how much the taxpayer can put into their 401K, but, of course, there’s NO guarantee that those 401K investments will perform. When a middle class self-employed person confronts a 48.3% marginal tax rate, if they can afford it, they are pretty much compelled to put money into their 401K. Then they can watch the S&P 500 and knock on wood. Since the S&P 500 is currently at the same level it was at back in June 2014, with governments and consumers across the world engulfed in maxed-out debt which renders them unable to continue to consume at the rates they used to, and global overcapacity idling shipping from Rotterdam to the Strait of Malacca, they’d better knock very hard indeed.

As for the pension funds for unionized government workers? If they become underfunded, though faltering investment returns, or retroactive benefit enhancements, or “spiking,” private citizens make up the difference through higher taxes and reduced services.

One final injustice must be noted: Once the private sector independent contractor retires, if they’re lucky they’ll collect around $25,000 per year in exchange for a lifetime of giving 12.4% of their gross income to the Social Security fund. And if that, plus their S&P 500 savings account’s 2.5% per year dividend income isn’t enough to live on, they’ll have to keep working. But wait! If that work earns them more than $15,710 per year, their Social Security benefit is cut by $1.00 for every $2.00 they make.

Let’s recap. A middle class private sector independent contractor pays a 48.3% tax on any income they earn between $81,500 and $118,500, which includes a 12.4% payment into Social Security on 100% of that income. Half of that 12.4% isn’t even deductible. If they invest money in a retirement account, there is at most a $24,000 ceiling on how much they can invest per year. If their retirement account tanks, there’s no bail-out. And if they still have to hold a job after they’ve finally qualified for full Social Security benefits after 45 years of work, there is a 50% tax on that benefit for every dollar they earn in excess of $15,710 per year.

By contrast, a unionized government worker in California collects a pension that averages – for a 30 year career – well over $60,000 per year (ref. here, here, here, and here). At most they contribute 12% into their pension fund via payroll withholding, in most cases much less. Their pension fund earns 7.5% and if it does not, the taxpayers bail it out. And when they retire, if they want to go back to work, there is NO penalty whatsoever assessed on their pension income.

Ensuring reasonable retirement security for Americans against the headwinds of unsustainable debt and an aging population is one of the great challenges of our time. And the biggest obstacle to finding solutions is that American workers do not adhere to the same set of rules. There is rather a continuum of rules, with unionized government workers at one privileged extreme, and independent contractors – those glibly lauded members of the “gig economy,” at the opposite end, paying for it all.

This is the context in which we have recently witnessed the irresistible alliance of Wall Street pension bankers and government union leadership annihilate the latest attempt at pension reform in California. Tax season brings it home in all its bitter glory.

 *   *   *

Ed Ring is the president of the California Policy Center.

18 Responses to How the Tax System Favors Government Workers and Punishes Independent Contractors

  1. Tough Love says:

    Ed, Nice comment. I have thought of that advantage before, as well as THIS one ….

    Even if lucky enough to be among the few who still get DB pensions, the typical PRIVATE Sector worker will not only be granted FAR less generous pensions (in BOTH formula-factors, AND in provisions such as the FULL unreduced retirement age and the NON-existence of COLA increases) but ALSO be at ANOTHER huge disadvantage vs their PUBLIC Sector counterpart.

    Even if they stay in the same industry and profession throughout their career, most Private Sector workers will have multiple jobs over their career. and even if each job had the identical DB pension Plan, the sum of the pensions from all of the jobs will often be half (or less) than what the DB pension would have been have they remained in ONE job throughout their career.

    The structure of PUBLIC Sector DB Plans is far different wherein (with some exceptions) Public Sector workers can more from position to position in far different agencies within gov’t and yet remain in ONE Plan throughout their career. This means that the final salary form the FINAL job is the ONLY one use (against the combined years of service) in the pension calculation.

    This is a HUGE Public Sector worker “advantage” and should be mentioned in any discussion of Public vs Private Sector pensions.

    • SeeSaw says:

      TL, there are multiple calculations used for a retiree’s pension amount if the employee worked for multiple agencies. Its not as simple as taking the final year’s salary times the total years’ service credit like is done if the retiree spent the entire tenure at the only/final entity.

  2. John Ben says:

    ED, As a self made man I have faced your comments in real life. I am now into 10 years of paying more into social security and guess what there is no increase in my benefits? What a rigid system we have, When I had my meeting with social security people 10 years ago they said that when I reach 80 years old I will have collected what I contributed. But I said that as owner of my company I had contributed both haves of the contribution? She said OH!

  3. SkippingDog says:

    A 401 is not a pension fund. It’s not complicated.

    • Tough Love says:

      No Skippy, that’s NOT an answer AT ALL.

      In fact for CA’s full career Safety workers (such as YOURSELF) who retire with 90% of final wages, taxpayer contributions towards their pensions in the last few years of employment sometime exceed $100,000 with no immediate taxation.

      If the comparable Private Sector worker were to save $100K, the excess above the 401K limit (of $18K, or $24K if already age 55) would have to come from AFTER-Tax income. The financial benefit (to ONLY Public Sector workers) of those FAR-GREATER tax-DEFERRED contributions is HUGE.

      Just another of the MANY MANY ways Private Sector taxpayers are abused at the behest of America’s insatiably greed Public Sector workers and enabled by our self-interested, taxpayer-betraying Elected Officials, BOUGHT with Public Sector Union Campaign contributions and election support.

      A re-set of this monumental decades-long financial “mugging” of Private Sector taxpayers is LONG overdue, and reneging on the 50+% share of their undeniably grossly excessive pensions (AND benefits) that assuredly would NOT have been granted in the absence of the Union/politician collusion would be a JUST and FAIR place to start.

      Taxpayers, …. refuse to fund Public Sector pensions …. an unjust THEFT of YOUR wealth.

  4. Smooth Moderation Anonymous says:

    “It’s not complicated.”

    Means it’s not complicated for normal people.

    The state has a contract to provide a pension based on a specified formula. Where they get funds to provide that pension is a political decision. If they choose to fund pensions on a “pay as you go” basis, then the tax question is moot. There is no claim of the tax system “favoring” military retirements.

    If there is an advantage, it is that, due to tax deferal the state can fulfill it’s contract (pension) at a lower cost to ………the taxpayer. (You’re welcome!!!)

    SkippingDog is one hundred percent correct, again. It is a pension, not a 401(k) or an IRA.

    Don’t you just hate it when you waste all that perfectly good math on a false premise?

    AKA GIGO LOL

    • Tough Love says:

      What an extraordinary “twisted” way to justify the UNDENIABLY multiples greater (when considering BOTH the richer formulas AND the more generous “provisions”) pensions granted Gov’t workers of all types …. but ESPECIALLY STATE and LOCAL Public Public Sector workers with the MOST generous, hence MOST costly, and hence MOST egregious pensions.

  5. Smooth Moderation Anonymous says:

    The topic of the day is taxes, Love.

    Moderation is not “justifying” anything. Merely correcting an error in logic.

    Moderation is not just a name, it is a way of life.

  6. Max says:

    How do you figure that the employee contribution to a public pension is more than $20,000 a year. For years, an $80,000 a year teacher paid 8%, which was $6,400. Next year, it will be 10.25%, which will be $8,200.

    You also have the wrong percent the self-employed pay into Medicare – it’s 2.9, not 1.9.

    Your analysis is technically correct for the income in the range you cite, but that certainly is not the tax rate the self-employed pay on their entire income.

    From a tax perspective, the marginal rates are the same for both employees and the self-employed. The only difference is that the self-employed have to pay the employer portion of Social Security and Medicare, a total of 7.65%. Hopefully, contractors are charging more for their time to make up the difference (and pay for their health benefits).

    • Ed Ring says:

      Max – Thanks for catching that, the reference to 1.9% was a typo, the total tax burden of 48.3% was and is correct and the chart already correctly referenced 2.9% (1.45% twice). The typo in the sentence has been fixed.

      Your other point is accurate, but that was the point. The MARGINAL tax rate on an independent contractor’s earnings is nearly half what they make. This means that if they are deciding to earn more, they know they will lose half of that money immediately to taxes. Even more to the point, they know that if they invest that money in their 401K, they have no guarantee it will perform, yet they are basically compelled to invest the money, since the investment would have to lose 50% in value before the decision to invest turned negative.

      It is difficult, for me at least, to see how any honest observer cannot empathize with the situation facing independent contractors based on the current tax laws. They are forced to put 12.4% of their money into Social Security, which gives them a return – expressed in “pension-speak” – of 0.8% at 68 (ref. “How Does “Zero-point-Eight at Sixty-Eight” Sound for a Pension Plan?“), and then, since that massive investment of their earnings will not give them a benefit that is even close to what they’ll need in retirement, they have to also find enough money left over to invest in a 401K plan with no employer matching and no guaranteed return – when the government workers their taxes support are getting pensions that are 2.0% at 60, or even 3.0% at 55, with employer matching as high as 4 to 1 with a guaranteed 7.5% return. As a final slap in the face, when they reach retirement age but still have to work, their Social Security benefits are cut by $0.50 for every $1.00 they earn over $15K/year.

      Imagine that your own 2015 tax choices confronted that reality, and ask yourself why government workers shouldn’t get the same deal as workers in the private sector? We are on track to have a higher percentage of the workforce as independent contractors than as government workers. And they are all getting screwed.

      One final thought – EVERY tax increase being proposed in California is happening to fund the already announced and scheduled increases in required contributions to public employee pension funds. EVERY ONE OF THEM. And it won’t be enough. Expect more (ref. “California’s Pension Contribution Shortfall At Least $15 Billion per Year“).

  7. Equal Time says:

    We now know from experience of the last 30 years that 401K’s are not a vehicle to save for a secure retirement. They are a tax-deferred investment vehicle that have proven to be volatile and beyond the knowledge and ability of individuals to effectively manage. Then there are the known and hidden fees that are reaped by the institutions administering them that translate into the only one assured of making money off a 401K is that very institution. To try and shove more people into such plans because they now have a more secure retirement plan than others is bad public policy and seeks to compound the problem of planning for a secure retirement, not solve it.

    • Tough Love says:

      Quoting Equal Time ….. “To try and shove more people into such plans because they now have a more secure retirement plan than others is bad public policy ….. ”

      Clearly the words of a Public Sector worker/retiree looking to keep the HUGE pension/benefit ADVANTAGE now in place.

      Earth to Equal Time ….. Public Sector workers are NOT “special” and deserving of a better deal … on the Taxpayers’ Dime.

      • Fact Checker says:

        Your comments are off my topic of the 401k model, but at least you do admit that DB plans are better for retirement security. You fail to address what retirement security benefit you see for individuals assigned to the 401k model and why you advocate piling more people into that model given its track record. Instead you resort to attacking the messenger rather than the message, which is a common tactic when one lacks a cogent argument. Go ahead – tell us how everyone will benefit from being put into the 401k model.

        • Ed Ring says:

          Our organization has NEVER advocated putting government workers onto 401K plans. You’re assuming that because, understandably, most pension reformers have given up on reforming pensions and as a result advocate throwing everyone onto 401K plans which would eventually solve the problem permanently. Our recommendations, which are well documented, can be summarized as follows:

          (1) Everyone who works in America, whether they work in the public sector or the private sector, must participate in Social Security.

          (2) Public sector pensions must conform to the guidelines set forth in ERISA. For example, lower rate of return assumptions must be adopted.

          (3) Underfunded public sector pensions must have solvency restored by a combination of lowering benefit accruals going forward for active workers and suspending COLAs for retirees. If that isn’t sufficient, across the board pro-rata cuts to benefits must be imposed on active (retroactive decreases to amounts of accrued benefits to-date) and retired participants.

          (4) Public employees, once #3 is implemented, must pay through payroll withholding 50% of the normal AND unfunded contributions towards their pensions.

          • Tough Love says:

            Ed, I agree with you suggestions, and it’s NOT that reformers are particularly advocating for 401K Plans but instead are advocating for some FAIRNESS ….. (far more easily determined in both Private and Public Sector Plans were DC than DB based)

            FAIRNESS would be for Taxpayer contribution towards Public Sector Plans equal (as a % of pay) to TYPICAL contribution of Private Sector employers into THEIR employees Plans. If that were achieved, they could care less in what investment vehicle it is placed.

            Public Sector workers

        • Tough Love says:

          Fact checker,

          Since your comment seems to be a reply to me, I will respond, but curiously, are you also posting as “Equal Time” …. seems that way from the flow of Commentator Names and your words “my topic of the 401K model”?

          (1) Quoting … “Your comments are off my topic of the 401k model, but at least you do admit that DB plans are better for retirement security. ”

          The ONLY real advantage of DB over DC Plans is the mortality sharing element, whereby (in DB Plans) one need not save for the prospect of living PAST their life expectancy, as those who save via DC Plans need to do. However, in the Public Sector arena, that benefit is (from the standpoint of Private Sector Taxpayers) FAR FAR outweighed by the HUGH screwing of the Taxpayers via the underhanded dealings and collusion between the Public Sector Unions and Elected Officials who grant far greater than necessary, just, fair (to Taxpayers) or affordable pensions ….. in exchange for Public Sector Union Campaign contributions and election support.

          (2) Quoting … “You fail to address what retirement security benefit you see for individuals assigned to the 401k model and why you advocate piling more people into that model given its track record.”

          The problem is certainly not any major difference in the 401K “model” vs the DB Pension “model” as an investment vehicle. The ONLY reason why Public Sector DB Plans provide so much greater retirement security than typical Private Sector DC Plans is because they are always Multiples more generous and THEREFORE multiples more costly, especially when the TRUE COST (not the phony, vastly understated cost that come from the “official” gov’t valuations using absurdly rosy assumptions and outdated methodology) is shown.

          Private Sector 401k Plan sponsors typically contribute 3% to 4% of pay into these Plans on their employee’s behalf. The TYPICAL NON-SAFETY worker Public Sector DB pension (when the cost is PROPERLY determined using appropriate and realistic assumptions similar to those REQUIRED by the US Gov’t of Private Sector Pans) has a level annual Total Cost of from 20% to 40% of pay, and the TYPICAL SAFETY worker pension has a level annual Total cost of 40% to 60% of pay. Did you think a COLA-increased pension often 90% of pay (for Safety) starting at age 55 (or even 50) comes without GREAT cost ?

          Sure, Public Sector employees contribute towards these Plans, but even AFTER subtracting the employee’s own contributions (typically about 5% of pay for non-safety and 10% for Safety) the balance that becomes the responsibility of the Taxpayers is about a level annual 15% to 35% of pay for Non-Safety, and 30% to 50% of pay for Safety.

          Who WOULDN’T expect DB Plans requiring such HUGE Taxpayers contributions to well outperform DC Plans with 3% to 4% of pay contributions annually.

          With little difference in Public/Private Sector cash pay in reasonably comparable jobs, there is ZERO justification for greater Taxpayer contributions towards Public Sector pensions (or Benefits) than what Private Sector workers get from their employers towards their own retirement Plans …… and right now it roughly 5 TIMES greater for non-safety and 10 TIMES greater for Safety.

          You fool no one with reasonable math skill and good common sense. It’s not DB Plan BEING DB PLANS that you support, it’s the VASTLY greater taxpayer contributions that can be sucked out of the taxpayer due to the complicated structure of DB Plans that is the reason for your support. The Taxpayers would NEVER contribute anywhere near such outrageous amounts under a DC Plan … and you know it.

          Personally, I’d love to let you keep DB pensions …. with the DB pension level determined by a 3% to 4% Taxpayer contribution plus whatever Public Sector employees employees want to add to that.

          EQUAL ….. but NOT better.

  8. Devin Carroll says:

    Great article!

    There is one point that should be noted:

    The articles states: “And if they still have to hold a job after they’ve finally qualified for full Social Security benefits after 45 years of work, there is a 50% tax on that benefit for every dollar they earn in excess of $15,710 per year.”

    Technically, this is not a tax but rather a cessation of benefits. Although that still sounds like a tax, the important point to note is that for every month that benefits aren’t paid, the Social Security benefit will increase (once they are turned back on).

    The Social Security earnings limit does catch a lot of workers by surprise! The rules can seem complex, but they really aren’t that hard to understand. Here is an article that I wrote on this topic.
    http://socialsecurityintelligence.com/social-security-earnings-limit-working-in-retirement/

    -Devin

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