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 so much better than putting money down the drain.
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 nonsense hurdle.
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:
Thanks to you and your dad for the table.
It doesn’t make me reconsider, but it sure is frustrating at times. Health care has to change in this country. I can barely afford to pay it every month!
Thank your dad for me 🙂 This post will help so many people.
I hope so! It helped me just writing it — learned so much.
Many thanks for breaking down the numbers in language this math dunce can understand! I can’t wait for the new digital guide by you and dad!
Great post! Have to admit, getting to the point of surpassing a great previous salary (working for someone else) is overwhelming somedays. But I do it because I see no limits, just like you said. Keep teaching us!
Wow…what an incredible resource. Thanks to you and your dad for putting this together. I am REALLY looking forward to the digital guide!
This. Is. Awesome. I honestly had no idea the differential was that big. Can’t wait to see the guide from you two!
It’s crazy, isn’t it? But good to know/understand so we can adjust accordingly…
Alexis-
Your point couldnt is a good one, but way off base. If you were to make simple chages in the structure of your business. IE Incorporate or LLC. There are numerous advantages that would work in your favor.
Simply put, you wouldnt “earn more for working for somebody else”. Here is how it works, lets say your are a W-2 employee, you pay taxes on exactly what you have earned each pay period, without the luxury of deductions. If you were to incorporate or form an LLC, when you pay your taxes quarterly you would “first” get to deduct any business expenses and then pay tax on the remaining amount. BIG Difference…
There is “NO” comparision to being self employed vs working for someone else….
Regards,
Susan
H
Hey Susan — Thanks for weighing in! Incorporating has its positives and negatives, I think. But this is how it works for a sole proprietor (which lots of us are). And those business expenses might be a deduction, but they’re still money out of your pocket.
I’m expecting to get some resistance to this post though, partly because there are so many variables depending on your biz, your personal situation, etc. Enjoy hearing other opinions!
Alexis, thanks for this break down. But I must say that the “money out of your pocket” philosophy behind it is only one way to look at business expenses (and therefore your tax burden). My business expenses are not money out of my pocket. I use my business to lead the kind of life I want to live and business expenses help to fund that.
Your tax burden is only on money that isn’t used to fund the business. And funding that business is an important economic responsibility we have as business owners. When you purposefully integrate life & business, you have the important to create a larger economic impact.
Traveling for business means more travel for me. Home office expenses (which I don’t think you brought up here and can add up big!) mean a bigger apartment, better technology, and reduced utilities. Money spent on “odd expenses” like photo shoots or videography mean a crazy fun experience I wouldn’t have had otherwise!
I now earn 4-5 times what I earned at any day job, so yes, I see this from an abundance perspective. But I think that distinction is a key factor in finding the enthusiasm & joy that running your own business takes.
Great points here! Thanks for taking the time to share your perspective.
I was an LLC. What many of these posters may not realize is that when you are incorporated, you pay taxes on the business income, then you also pay all of these taxes when you pay yourself from the business!
Thanks so much for this! Great insight, especially as I prepare to take that leap from full-time employee to self-employed.
So excited for you, Ami!
Thanks Alexis to both you and your dad!
Obviously I’m on the other side of the pond and our healthcare is free (I know sorry about that!) but our taxes are super high. Still I’m going to use the approach and Irish ize it! Thanks again. I’m happy to hear you’re better off working for yourself.
Ellie
Blog post that sits nice with this is here : http://workingsirens.com/top-3-tips-to-ditch-your-high-paying-job-and-take-a-chance/
I love the post and the excel sheet! But what about the tax advantages of 401K and IRA and the associated company matching programs?
Hey — I mention that briefly as something that was too complicated to include but you should certainly consider! Not to mention paid vacation, maternity leave and other employee benefits.
This is so timely for me as I move from having a salary to my main gig,
http://www.facebook.com/raisingdigitalnatives and my various side hustles, each of which is taxed differently. Conferences are well-funded in academia so even with a low salary, you could stay at the conference hotel, etc. I’ll be going to lots of conferences in my region and staying with friends now, at least until my balance sheet is healthier. I do like the work life integration, and my own digital native is getting some cool gadgets out of my business, for sure.
Alexis — This is a great post. As someone who has spent the majority of non-academic adult life as a self-employed individual, I have often felt this. It’s great that you were able to point this out with the numbers.
This is the most epically useful post I’ve ever read.
It’s easy to understand, practical, and free. I definitely would have paid for information like this.
Thanks Alexis. Thank you Alexis’ Dad. I wish I knew your name but I don’t. So just thanks Daddy Lexis.
this is fantastic, thank you! looking forward to the guide.
They call that Job Lock. As far as I know, the US is the only country in the world that ties health insurance to employment; makes you think they actually don’t want people working for themselves doesn’t it.
Thanks so much Alexis for all your time and to your dad too! VERY helpful!
:o)