What You Should Think About Before Becoming Self Employed

Jane Young, CFP, EA

Image result for self employment imagesGoing out on your own as an independent contractor, a consultant or a small business owner is a major decision that can have significant financial implications. You will need to earn 20% to 40% more as an independent contractor than as an employee just to stay even. Self-employed individuals have to pay twice the amount in Social Security and Medicare taxes because they have to cover the portion that employers normally pay. On your own, you will have to pay 12.4% in Social Security, on income up to $127,200, and 2.9% in Medicare. Higher income individuals will also have to pay a Medicare surtax of .9%.

Additionally, taxes will no longer be automatically withdrawn from your paycheck. You will need to start paying quarterly estimates directly to the IRS. It may be wise to hire a tax professional to do some tax planning and help you determine how much tax you should pay each quarter.

Another major expense associated with becoming self-employed is the loss of employee benefits. These may include health insurance, disability insurance, life insurance, and workers compensation. Additionally, you will no longer be eligible for bonuses, profit sharing, unemployment insurance, sick pay, and vacation pay.

Once you leave your company, you can’t contribute to your 401k plan and you will lose the opportunity receive an employer match on your contribution. As a self-employed person you will need to establish an alternative retirement plan such as an IRA, SEP (Simplified Employee Pension) or Solo 401(k). If you leave your employer and decide to move your 401k plan, do a direct rollover to an IRA to avoid income tax and potential penalties.

When you go out on your own you will have more freedom over your compensation, the hours you work and the services you provide. Although you should earn a higher hourly rate you may have less job stability and inconsistent cash flow. Self-employed individuals generally need to maintain a larger emergency fund as a buffer against a less consistent income stream.

In addition to greater freedom and a potential increase in earnings, one the biggest advantages to becoming self-employed is the opportunity to deduct normal business expenses. This may include your cell phone, computer, internet, health insurance, mileage, office expenses, travel, meals and entertainment, business insurance, marketing expenses, accounting expenses and potentially a home office deduction. The ability to deduct your expenses can result in a tremendous tax savings. One of the biggest mistakes made by those new to self-employment is a failure to keep track of all their business expenses.

Becoming your own boss can be very rewarding and can provide you with more control over your career. However, independence and freedom comes with added expenses and less stability. The rewards can be tremendous if you understand and plan for the added expenses and truly feel comfortable with more variability in your income.

401k Loan Not a Great Idea

Jane Young, CFP, EA

When you need extra money to pay some bills, make home improvements or buy a new car, a 401k loan may seem like the perfect solution. At first glance, it seems like a great idea to borrow money from your 401k account and pay interest back to yourself. However, in reality taking a loan against your 401k can put a significant dent in your retirement saving and could result in unnecessary taxes.

Most 401k plan providers allow employees to take loans against their 401k account of up $50,000 or 50% of the account value. The interest rate charged on most 401k loans is the prime rate, which is currently around 4%, plus 1 or 2 percentage points. Loans must be paid back in five years, potentially longer if you are borrowing to purchase a primary residence. Repayment is typically made via automatic payroll deduction and loans automatically come due if you discontinue employment.

The advantages of a 401k loan include the ease with which you can get your money. A 401k loan is a quick, no hassle process that doesn’t require a credit check or the completion of a time consuming credit application. The loan is automatically repaid from your paycheck and the interest rate is generally lower than what you would pay for a bank loan or a credit card. There is no income tax or penalty due on the money taken out for the loan and the interest goes back into your account.

On the surface this sounds like a great deal but there are significant disadvantages. The most obvious may be the opportunity cost of losing the chance to earn compounded returns on the money that you have borrowed. This can have a dramatic negative effect on the amount of money you have available at retirement. Additionally, while making payments on a 401k loan, most borrowers stop making contributions. This results in lost tax deductions and may cause you to miss out on your employer’s match, not to mention less money in retirement.

Another less obvious downfall is the double taxation on the interest. Your interest payments are made with after tax dollars and then you pay taxes a second time when distributions are taken in retirement. Additionally, you may have to pay taxes and penalties if you lose or quit your job before your loan is paid off. A 401k loan typically becomes due within 60 days of separation from your employer, regardless of the reason. If you are unable to pay off the loan you will owe regular income tax on the full amount plus a 10% penalty if you are under 59 ½.
Generally, you are better off taking out a bank or home equity loan or postponing consumption until you can pay cash than taking out a 401k loan. Avoid 401k loans unless you are truly in dire circumstances or the money is needed for a very short term loan.