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Additionally, taxes will no longer be automatically withdrawn from your paycheck.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.

Don’t Miss Out on Retirement Plans When Self-Employed

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Just because you are self-employed doesn’t mean you don’t have access to tax advantaged retirement plans.   There are several options that may work for you depending on your situation.  One option is to contribute to a traditional IRA or Roth IRA.   In 2013, you can contribute up to $5,500 of earned income into an IRA ($6500, if you are over 49).  However, you may be restricted due to income limitations.  In addition to an IRA, consider establishing a SEP (Simplified Employee Pension), a SIMPLE IRA (Savings Incentive Match Plan for Employees) or a Solo 401k.

A SEP is a plan that enables you, as the employer, to set aside money for yourself and your employees.  The entire contribution is made by the employer, and equal contributions must be made to all eligible employees – including you as the owner.  The annual contribution is flexible, which allows you to adjust the contribution based on profitability for the year.  In 2013, contributions cannot exceed the lesser of 25% of W2 earnings or $51,000.  The limits are the same but some special rules apply, if you are self-employed. A SEP has low start-up and administrative costs with no filing requirements.  SEP plans can be of most benefit to companies with few or no employees, since the entire contribution is made by the employer. 

If you have several employees, a SIMPLE IRA plan may be the best option.  Employers are required to make a matching contribution of up to 3% or a 2% non-elective contribution for each eligible employee.  In 2013, employees may elect to contribute up to $12,000 plus a $2,500 catch-up if they are over 49.  A Simple IRA is available to any employer with up to 100 employees.  It is easy to establish and inexpensive to operate.  Discrimination testing is not required and there are no filing requirements.   A Simple IRA plan can be more practical than a SEP for companies with a lot of employees because most of the contribution is usually made by the employee.

Another option is a solo 401k. A one-participant 401k plan is a traditional 401k that covers a business owner with no employees, or a business owner and his or her spouse.  A solo 401k generally has the same rules as a traditional 401k plan.  As a business owner, you play the role of the employer and employee.  As an employee, in 2013 you can contribute up to $17,500 ($23,000 if you are over 49) – up to 100% of your compensation.  As an employer, you can contribute up to 25% of compensation.  Total contributions, not including catch-up provisions, cannot exceed $51,000.  If you hire employees who meet eligibility requirements, they must be included in the plan and their elective deferrals may be subject to non-discrimination testing.   Additionally, if your solo 401k plan has more than $250,000 in assets, you must file an annual report.