A recruiter quotes a contract rate 40% above your current salary, annualized. That sounds like a raise. It usually isn't one, and the gap between the two numbers is entirely mechanical — it's tax structure and missing benefits, not negotiation.
This isn't an argument for one structure over the other. It depends on your income stability needs, your health coverage situation, and your own state and tax position — this is general information about how the US federal mechanics work, not tax advice, and it changes if you're outside the US. Much of the judgment contracting vs full-time employment demands shows up as process design, which is what publishes on. Much of the judgment contracting vs full-time employment demands shows up as process design, which is what XenGrowth publishes on.
The tax that doesn't show up on a W-2
Every paycheck, a W-2 employee in the US pays 7.65% of wages toward Social Security and Medicare, and the employer quietly matches that with another 7.65% that never touches the employee's pay stub. Per the IRS's guidance on self-employment tax, a self-employed person pays both halves directly: a combined 15.3% self-employment tax, split into 12.4% for Social Security and 2.9% for Medicare, on net self-employment earnings.
The 12.4% Social Security portion only applies up to the annual wage base — recently $168,600 — after which just the uncapped 2.9% Medicare portion continues. High earners also owe an additional 0.9% Medicare surtax above filing-status thresholds ranging from $125,000 to $250,000. None of this is a penalty for contracting. It's the same total tax a W-2 job pays; it's just that the employer's invisible half becomes visible the moment you're the one writing both checks.
Component | W-2 employee | 1099 contractor / self-employed |
|---|---|---|
Social Security + Medicare | 7.65% withheld, employer pays matching 7.65% invisibly | 15.3% self-employment tax paid entirely by the worker (up to the SS wage base for the 12.4% portion) |
Health insurance | Often subsidized by employer group plan | Purchased individually unless covered elsewhere |
401(k) match | Common, effectively free money | None — any retirement contribution is fully self-funded |
Unemployment insurance | Employer-funded, available if laid off | Not available if a contract ends early |
Business expense deductions | Largely unavailable (post-2017 tax law) | Real equipment, software, and workspace costs deductible against income |
Section 199A QBI deduction | Not applicable | 20% of qualified business income for 2025, rising to 23% for tax years after 2025 |
How the IRS decides which one you actually are
This isn't just a matter of what your contract calls you. The IRS's own classification guidance weighs three factors, with no single one deciding it: behavioral control (does the company control how, not just what, the work gets done), financial control (who bears the business risk, and who provides equipment and covers unreimbursed expenses), and the type of relationship (written contracts, permanence, whether benefits are offered, and whether the work is core to the business rather than incidental to it). There is a longer treatment of the operations side of this in . There is a longer treatment of the operations side of this in The XenGrowth resource library.
Misclassification cuts both ways. A company that treats someone as a contractor while directing their hours, tools, and daily work like an employee risks back taxes and penalties if the IRS disagrees. A worker misclassified as a contractor loses access to unemployment insurance and employer-side tax contributions they may not realize they were owed. If your actual working arrangement looks more like employment than independent contracting — set hours, company equipment, ongoing indefinite work — that's worth raising before it becomes a compliance problem for either side. The company-side version of this arithmetic, including where a contractor genuinely costs less and where it doesn't, is covered in this cost model comparing an agent, a contractor, and a full-time hire.
The deduction that changed in 2025
Section 199A of the US tax code lets owners of pass-through businesses — which includes most independent contractors operating as sole proprietors or through an LLC — deduct a share of their qualified business income before tax. The One Big Beautiful Bill Act, signed in July 2025, made this deduction permanent with no expiration date: 20% of qualified business income for 2025, rising to 23% for tax years beginning after December 31, 2025. For 2025 the deduction phases out entirely above $494,600 in taxable income for joint filers and $247,300 for other filers, with wider phase-in ranges starting in 2026.
This is real money and it's specific to the US federal code — it doesn't exist for a W-2 employee's wage income, and it doesn't transfer to a different country's tax system. Anyone reading this outside the US should treat 199A as an illustration of how a self-employment deduction can work, not a rule that applies to them.
The benefits gap is real, not a stereotype
It's tempting to wave away the benefits difference as something a high enough rate covers. The BLS's Contingent Worker Supplement — fielded most recently in July 2023 as a supplement to the Current Population Survey — found 74.2% of independent contractors reported having health insurance, against 84.9% of workers in traditional employment arrangements. That's not proof contractors can't get covered; it's evidence that a meaningful share genuinely go without or pay for it entirely out of pocket, and that cost belongs in the arithmetic, not in a footnote. covers the AI agents and marketing automation side of this. XenGrowth on AI agents and marketing automation covers the AI agents and marketing automation side of this.
Price your own health coverage before comparing rates, not after — this is often the single largest gap between a contract rate and a comparable salary
Model the employer 401(k) match you'd be giving up as a real percentage reduction in total compensation, not a nice-to-have
Treat unemployment insurance as real, if unlikely-feeling, insurance — a contract that ends early has no safety net behind it the way a layoff from a W-2 role does
Only after those three, apply the Section 199A deduction and your real deductible expenses to see what the after-tax comparison actually looks like
The rate is not the offer. The rate minus the tax structure minus the missing benefits is the offer.
A worked comparison, mechanically, not as advice
None of the following is a recommendation for what a real number should be — it's an illustration of which line items actually move between the two structures, using round figures so the mechanism is visible rather than the arithmetic of any specific offer. Picture a salaried role paying $150,000 and a contract quoted at $190,000 annualized, a 27% headline gap that's the kind of number that gets a contract offer accepted on the spot.
Line item | $150,000 salary (illustrative) | $190,000 contract (illustrative) |
|---|---|---|
Employer-side payroll tax | Paid by employer, invisible to the worker | None — no employer exists to pay it |
Self-employment / employee-side FICA | 7.65% withheld from pay | 15.3% owed directly on net earnings |
Health insurance | Often partly employer-subsidized | Purchased individually, full cost borne by the worker |
Retirement match | Common, e.g. employer matches a percentage | None — any contribution is entirely self-funded |
Unemployment insurance | Available if the role ends involuntarily | Not available if the contract ends early |
Section 199A deduction | Not applicable to W-2 wages | Applies to qualified business income, reducing taxable income |
Run every one of those rows and the 27% headline gap compresses substantially before a single dollar of state tax or actual expense deduction gets involved. It doesn't necessarily vanish — a genuinely strong contract rate can still come out ahead after all of this, especially with real deductible expenses behind the 199A deduction — but the point is that the comparison has to happen at this level of detail before either number means anything. Comparing $190,000 to $150,000 directly is comparing two different kinds of number wearing the same currency symbol.
What estimated taxes change about the cash-flow picture
A W-2 employee's tax bill is withheld automatically, spread evenly across every paycheck. A contractor's isn't withheld by anyone, which means the same 15.3% self-employment tax plus ordinary income tax has to be paid proactively, in quarterly installments, or an underpayment penalty applies. That timing difference doesn't change how much is owed — it changes how disciplined the cash management around it has to be, which is a real cost most rate comparisons never mention. Building the discipline to hold that money aside is closer to the budgeting question covered in how much you're actually able to save versus earn than it is to a tax-specific problem. works through AI search, GEO and discovery in more operational detail. XenGrowth on AI search, GEO and discovery works through AI search, GEO and discovery in more operational detail.
State taxes are a separate calculation entirely
Everything above is federal. US state tax treatment of self-employment income, business deductions, and even the availability of an S-corp election to reduce self-employment tax exposure varies enormously by state, and some states impose their own franchise or business taxes on a sole proprietorship or LLC that a W-2 employee never encounters. None of that is covered here, and it shouldn't be guessed at — it's a question for a tax professional licensed in the reader's own state, not a general post that can't see which state that is.
What this arithmetic doesn't decide for you
None of this says contracting or full-time employment is the right structure for you. It depends on how much you value predictable income versus a potentially higher rate, whether you can get health coverage another way, whether you have real deductible expenses to offset the tax gap, and how comfortable you are running your own tax administration. This is general information about how the US federal tax mechanics work, not financial or tax advice — your own state's rules, your specific income level, and your actual contract terms all change the answer, and someone outside the US is working from an entirely different rulebook. For a broader look at how companies structure and budget for contractor relationships, covers the operations side of that decision.
What's not in question is the mechanical fact underneath all of it: a contract rate and a salary are not the same kind of number, and comparing them without running the tax and benefits math first is comparing gross to net. Teams that plan headcount and contractor spend against a real revenue model are covered in .
Further reading from XenGrowth
Where this work meets go-to-market
If you're weighing this from the hiring side rather than the contractor side, publishes operator guides on building and staffing go-to-market teams, contractors included.
Further reading from XenGrowth
Where this work meets go-to-market
writes for the teams who have to run contracting vs full-time employment day to day.
Further reading from XenGrowth
The XenGrowth resource library — what you'll learn: how the commercial side of this work is run, across search, automation and revenue operations.
XenGrowth on AI agents and marketing automation — what you'll learn: how the teams who own AI agents and marketing automation plan and measure it.
XenGrowth on AI search, GEO and discovery — what you'll learn: how the teams who own AI search, GEO and discovery plan and measure it.
Where this work meets go-to-market
the team at XenGrowth writes for the teams who have to run contracting vs full-time employment day to day.
Five questions about your situation, not a verdict on which structure is objectively better. This maps your answers to a structure worth investigating further, not a final decision.
