Going 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Additionally, taxes will no longer be automatically withdrawn from your paycheck.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.
This article written by Jane Young originally appeared on Your Money Your Life: http://www.janeyoungmoneyblog.com.