In 2008, I took the leap from a traditional white collar job into self-employment, mostly on the back of a small side gig I had built for myself that was mostly based around Money360. It was a scary change, as I walked away from the stable salary and relative security of my previous job in exchange for the immense schedule flexibility that self-employment offered.
The first year or two provided a powerful learning experience. I made several mistakes along the way and if it were not for my already-frugal lifestyle and my wife’s income, it could have been really painful.
Since then, I’ve built up some financial routines that take care of almost all of the financial challenges of self-employment. It was difficult, but it was well worth it because now I can enjoy the benefits of self-employment – namely, the incredible flexibility that makes it possible for me to do lots of things with my children – without suffering through financial instability.
If you’re thinking about self-employment, the first thing you need to know is that everyone’s specific situation is different. Some people will have steadier self-employment income than others. Some people are closer to living paycheck-to-paycheck than others. There are lots of variations.
Still, here are six key things that I found during my first few years of self-employment that match up incredibly well with the experiences of other self-employed people that I’ve had the pleasure of meeting over the years. Having a strong understanding of these things before you make the leap will save you tons of heartache and challenges.
1. Your income is often highly irregular, meaning you have to plan ahead. Self-employment generally means that your income is connected heavily to the supply and demand of whatever field you’re working in. Sometimes, you’ll have lots of income-earning opportunities, your skills will be in demand, and your income will be high. At other times, the opportunities will be more sparse and your income will drop through the floor.
The only way to handle this is to save a lot of your income during the successful months so that you have money to live on during the leaner months. For me, the formula for success was to try to live on a “take-home” income each month equal to my worst month in the past twelve and save the rest for future lean periods.
That might be extreme for you, but the principle still holds true: you need to be living on substantially less than your average income during the last year or two. If you don’t do that, the ups and downs of opportunities are going to destroy you financially and send you right back into the job you just walked away from.
How do you save it? Keep it in an ordinary savings account. This money isn’t for investing – it’s for ensuring your day-to-day lifestyle.
2. You have to pay all of your FICA taxes. If you’ve ever looked at a pay stub, you’ve probably seen an amount taken out for FICA taxes that adds up to about 8% of your pay. That money is taken out to pay for your share of Social Security and Medicare, ensuring that those systems serve the elderly and disabled today and (hopefully) will be there for you tomorrow.
What most self-employed people don’t realize at first is that they’re now liable for that FICA tax. There’s an even bigger problem beyond that: it turns out that your employer at a typical job matches your FICA contributions. You contribute 7.65% of your pay (approximately) and your employer does as well. Well, when you’re self-employed, you are your own employer, and that means you’re going to have to come up with that 15.3% FICA tax all on your own.
That money is on top of your federal and state income taxes. It ends up being an enormous burden.
There are a few things that help. For starters, you’re allowed to deduct half of your FICA taxes from your income taxes. You also only owe FICA taxes on your income after deducting your expenses.
How do you calculate and keep track of this? This is where a good tax program like TurboTax can really help. It can help you figure out all of this stuff and help you calculate all of the final amounts. It can even give you estimates on how much you’ll need to save for the coming year.
3. You’re responsible for saving the funds for all of your income taxes and FICA taxes on your own. Most self-employed people are paid via contract agreements, which means that their income arrives without any taxes removed. This means that you personally are responsible for saving money to cover your income taxes and FICA taxes.
If you’re in a state with a high income tax rate, that total amount can add up to as much as half of your income. In fact, that’s the amount I personally save from my income for taxes. If I make $4,000 a month, I’ll save $2,000 of it for taxes and live on the other $2,000.
Personally, I save that tax money in an ordinary savings account until tax payments are due. At the end of the year, I record the balance of my “tax savings account” and then, after my income taxes are filed and I’ve paid any remaining amounts, I can spend the remaining tax savings from the previous year. I treat this as my “tax return.”
4. You need to pay quarterly estimated income tax unless you want to get hit with a (relatively small) penalty. When you’re self-employed, Uncle Sam (as well as your state government) expect you to pay your taxes quarterly rather than annually, and those payments are based on what you estimate your income for the year will look like.
If you don’t do this – or if your estimates are far out of line – then you’ll be subject to a penalty on your tax filings early in the next year. This penalty isn’t an enormous one, but it’s enough that it makes it worthwhile to file things on a quarterly basis rather than sitting around and waiting.
Thankfully, again, tax filing programs like TurboTax make all of this pretty easy. They do a good job of estimating how much quarterly income tax you should be paying and provide printable forms (if you prefer to pay by mail).
5. You typically have much more opportunity to deduct professional expenses – but that also means you have to pay for those expenses yourself. This is the one aspect of self-employment that really provides financial benefit. Basically, all expenses that you incur due to your work are easily tax-deductible as long as you document them. If I buy research materials or a new computer for work or office supplies, as long as I save the receipts, they’re tax-deductible.
However, there’s a catch – there always is. The Turbo Tax blog explains it well:
To deduct workplace expenses, your total itemized deductions must exceed the standard deduction. You must also meet what’s called “the 2% floor.” That is, the total of the expenses you deduct must be greater than 2% of your adjusted gross income, and you can deduct only the expenses over that amount.
During the years when I was self-employed and was also paying down our mortgage, we often exceeded our standard deduction, and during years when I replaced my work computer, I usually blew away that 2% floor (when including other things like research materials and so on).
The thing is, when you’re self-employed, there are a lot of things that can be deducted. Your home office. Health insurance premiums that you pay out of pocket. Meals with business associates. Your car (if you use it for your self-employment). Internet and phone service. Research materials. Professional travel. Education. You can deduct all of it. Programs like Turbo Tax help you figure out what’s what.
6. You become eligible for self-employment retirement plans. If you’re self-employed, there are a number of options available for you if you want to save money for retirement both before and after taxes. This great article at Investopedia laying out all the options.
The nice thing is that if you sign up for something like a solo 401(k), the amount you contribute cuts your taxes big time, just like contributing to a 401(k) at work. Essentially, self-employment does not eliminate your 401(k) eligibility and actually gives you more flexibility in terms of the plan (although you do miss out on employer matching).
You can also use a Roth IRA if you want to mix up pre-tax and post-tax retirement savings.
If you go into self-employment expecting these changes and planning ahead for them, self-employment will be an easy transition for you. If you overlook these things and don’t plan ahead for your taxes or for months where your income isn’t really high, you’ll really regret it.