When I decided to leave my day job and work on my business full time, one of the first things my dad-slash-financial-advisor helped me with was figuring out how much money I needed to earn — both to maintain my standard of living and to meet my life and financial goals.
Because while there are lots of benefits to working for yourself, this is a most definite down side: you have to earn more money when you work for yourself to end up with the same take-home paycheck you’d get as a company employee.
This is absolutely nuts, especially when our economy needs jobs. Here I am, creating a job — not to mention creating paychecks for the six or seven contractors who work on my team — and there’s a HUGE disincentive to keep at it.
But that rant is for another blog post (coming soon). This post is about explaining the WHY. Why do you need to earn more money when you’re self-employed than when you’re working for someone else?
If you’re thinking about making money on your own terms, whether that’s starting a side hustle in addition to your day job or turning your passion into a full-time income, you’ll want to understand this financial
As a sole proprietor (and that’s an important distinction because taxes will affect you differently if you’re incorporated or have some other fancy title), here are the four places you’ll get hit harder than if you worked for a company:
1. Social security tax. It’s 10.4 percent. If you work for yourself, you pay it all. If you work for a company, you pay 4.2 percent and your employer pays 6.2 percent.
2. Medicare tax. It’s 2.9 percent. If you work for yourself, you pay it all. If you work for a company, you pay 1.45 percent and your employer pays 1.45 percent.
Social security plus medicare is often referred to as the self-employment tax. It’s a total of 13.3 percent (on income up to $110,100).
3. Business expenses. Being able to “write off” expenses like conferences and office supplies and lunch with important people is often seen as a benefit, but don’t forget that if you worked for a company, they’d cover those costs. Expenses range significantly depending on what kind of business you’re running and how you choose to spend your money, but it does tend to add up, even if you go lean.
4. Health insurance. If you can jump onto your spouse’s insurance, you might not have to worry about this. But for the rest of us, you’ll likely spend more — perhaps significantly more, depending on your health and the kind of coverage you need — by purchasing insurance on your own than if you signed up through your employer.
Now, this doesn’t even go into other employer-sponsored benefits like maternity and sick leave, vacation (no paid time off when you work for yourself), 401k match, disability insurance… but these are the four components that tend to make it difficult for freelancers and consultants and solopreneurs to make a living.
Still having trouble visualizing just how much of a difference this will make in your take-home pay? Here’s a table my dad, an accountant, put together (with my help) to show how much money you’ll end up with if you’re working for yourself verses working for an employer.
Oh, and we're excluding state taxes for simplicity's sake; this deals only with federal taxes. And yes, that means you have to pay MORE tax than what you see here.
In both of these situations, the worker earns $75,000/year — one works for a company and the other is self-employed. (Click the image if you prefer a larger version.)
That yellow row at the bottom is spendable cash, otherwise known as take-home income. Notice how much LESS the freelancer takes home — $49K vs. $58K.
Keep in mind that components like health insurance and business expenses are highly variable. We estimated on the LOW end for business expenses, mostly so no one could blame the sizable differential on that. But a lot of small businesses have more than $4,000 of expenses each year, especially if you go to a conference or two.
So how much would you need to make while working for yourself to end up with a take-home pay that’s equal to the employee who earns $75,000/year?
That’s what this next table explains:
See how numbers in the yellow row match this time? Both workers have a take-home pay of $58K.
We worked backwards to figure out how much the sole proprietor would have to earn to take home as much as the employee who earns $75,000. And the answer is… $88,710.
Yes, you read that right. You’d have to earn $13,710 MORE — that’s an additional 18 percent! — to take home as much as the company employee.
So what’s the GOOD news, you ask?
The good news is that when you work for yourself, you are bound by no one’s limitations but your own (click to tweet that idea). You don’t have to wait until your one-year mark to ask for a raise — you simply get out there and hustle your butt off if you want to make more money. And if you’re willing to hustle, you have the potential to make far more than you made at your day job (which, by the way, I’m doing, not even a year after going off on my own).
Yes, more of your hard-earned cash will go to taxes. But that makes those of us who value freedom in our work and life push that much harder to earn a living. It makes us that much more determined to succeed.
What do you think? If you’re already bringing in money on your own terms, do you feel the burden of the self-employment tax? The sting of health insurance? Why do you choose to face those costs rather than work for a company?
For those of you who are thinking about working for yourself, does this make you reconsider?
If you found this post helpful, here are two resources with more information:
- How I Surpassed My Day Job Income in Just 6 Months of Self-Employment is full of practical advice, including the juicy financial details behind my own personal transition to career freedom.
- My dad and I are co-writing a digital guide on all the financial stuff you need to know when working as a freelancer, consultant or entrepreneur — basically a biz money guide for non-financial people. If you want a heads up when it becomes available, sign up for my newsletter.