( This article appeared previously on Marketwatch.)
Working for yourself is liberating — and extraordinarily expensive.
You face steep tax bills, have to buy your own health and disability insurance, and need to fund retirement with no help from an employer. Add it all up, and the numbers start to look ugly.
Tempted to join America’s 15 million self-employed? Here’s a reality check.
Imagine you are single, you claim the standard deduction and one personal exemption, and you have $100,000 in annual income.
If you are self-employed, you would have to cough up $30,582 to Uncle Sam, thanks to a combination of federal income taxes and Social Security and Medicare payroll taxes, according to the 1040 Tax Estimator for 2015 at Dinkytown.net, a website specializing in financial calculators.
One financial planner tells clients to set aside a third of their self-employment income for federal, state and local income taxes.
By contrast, you would need to pay $25,869 in federal taxes if you were somebody else’s employee, $18,219 as a retiree living off traditional retirement accounts such as an individual retirement account or 401(k), and $7,838 as a retiree drawing down a regular taxable account where every dollar was taxed at the long-term capital-gains rate. (I’m assuming our hypothetical retirees are in their early 60s and don’t benefit from the slightly larger standard deduction available to folks age 65 and older.)
Why do you pay the federal government so much more if you are self-employed? The big difference is the payroll tax, which accounts for $14,130 of the $30,582 tax bill. If you work for somebody else, your employer pays part of the payroll tax, so your portion would be just $7,650. Retirees, for their part, don’t pay the payroll tax, because they don’t have earned income.
“It’s a shock to people the first year they do this,” says Cincinnati, Ohio financial planner David Foster. He tells clients to set aside a third of their self-employment income for taxes, since they will have to pay not only the federal government, but also state and local income taxes.
If you go from employee to self-employed, you also will lose all the benefits provided by your former employer, which might have included health and disability insurance.
It is expensive, as well as a hassle, to get this coverage on your own. For instance, it could cost $3,400 a year for an individual health-care policy and $8,500 for coverage for a family of three, based on eHealthInsurance.com’s price index.
What about disability insurance? Foster says a 40-year-old lawyer making $100,000 might pay $2,200 a year for coverage. He advises buying disability insurance before you quit your current job, because the coverage may be harder to get once you are self-employed.
One piece of good news: These insurance premiums should be tax-deductible. In fact, working for yourself offers the chance to deduct all kinds of business expenses. But this isn’t as big a benefit as folks imagine.
“People think that, when something is deductible, it’s free,” notes Alexandra Demosthenes, a financial planner in Boca Raton, Fla. “But you might be saving just 25 or 28 cents in taxes for every dollar you deduct.”
Among 401(k) and other defined-contribution plans overseen by Vanguard Group, 94% include an employer contribution. Employees also find it relatively painless to fund these plans, because their retirement savings are automatically deducted from their paycheck.
For the self-employed, the entire burden is on their shoulders. But for those who make the effort — and can afford to — there is an upside: You can potentially put away far more for retirement, Foster notes.
For instance, in 2015, the maximum contribution that an employee can make to a 401(k) plan is $18,000, or $24,000 if you are age 50 or older. But if you are self-employed and set up a solo 401(k), you could potentially sock away $53,000, or $59,000 if you are 50 or older.
Still tempted to launch your own business? Keep a few other issues in mind. You should probably build up a larger emergency fund, because you no longer will have a steady income — and there may be stretches when you don’t earn anything.
“People are used to having sick days and vacation time,” Demosthenes says. “But now, if you aren’t doing the job, you aren’t getting paid.”
Depending on your business, you might need to hire an accountant and you could have to pay sales taxes. You also may want to protect your personal assets from creditors by setting up the business as an S corporation or a limited liability company, rather than operating as a sole proprietorship, with no separate legal structure for your business.
“If you’re designing brakes for roller coasters,” Foster says, “you’re going to want to do that in an LLC.”
Next Avenue Editors Also Recommend:
- Self-Employment: How to Know if You’re Cut Out for It
- Why Being Self-Employed Can Be a Good Career Move
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