Self-Employment 101

Self-Employment 101

The journey from working as an employee for someone else and launching your own business can be exhilarating.  It can also be overwhelming and sometimes even terrifying.  The more you study and learn about self-employment, the more you’ll realize you don’t know.  That’s okay.  There are countless resources to help you and professionals to guide you. 

Here are three very common areas of inquiry for the newly self-employed that can help get your self-directed education off to an excellent start. 

Accountability and Accounting

Perhaps the first and most important thing you can do to achieve your desired level of self-employment success is set in place a solid record-keeping system.  Accurate record keeping is critical to you and your new business.

Practicing meticulous accounting in real time is the best way to ensure you won’t find yourself in tax trouble.  You should save every receipt and write down every expense as it is incurred.  Even if you’re not certain if it’s a deductible expense or not, save the original receipt and record it in the moment, then let your tax professional make the final call.

It’s better to have the details recorded and not need them all, than reach tax time and learn you only have a fraction of what you need.  In addition to accurately tracking all expenses, you need to be diligent about recording every dollar of income you earn, too.  Total earnings reported needs to be exact, not an estimate.

Accuracy in accounting is vital to the success of your business, as is accountability.  Your business won’t be sustainable over the long haul if you fly by the seat of your pants in running it.  Develop a business plan with long and short-term goals, then hold yourself accountable to execute the steps that will help you meet your professional objectives.

Taxes and the Self-Employed

Understanding how taxes work for the self-employed can be difficult, especially if you’ve always worked as an employee for someone else and have never considered tax implications from the employer perspective.  Your accountant or trusted tax professional will be essential to you as you navigate these uncharted waters of working for yourself.

Here’s a crash course in the basics so you’ll have a general idea of what to expect.  First, you will still pay taxes, but since you won’t have tax withholdings automatically deducted from your paychecks, it’s your responsibility to figure out exactly how much you will owe the IRS.  Whether your self-employment is a part-time supplement to your full-time income, or whether it’s your only job, you’ll be responsible for paying taxes on your earnings any year during which your earnings are $400 or more from self-employment.

To avoid being caught off guard and having a big tax bill owed the IRS, you should plan to set aside between 25-30% of all earned income.  As you set up your business banking, open both a checking and savings account, and every time you earn income, deposit the 25-30% you’re stashing away directly into savings to cover your taxes.  It’s possible you won’t need that high a percentage, but better to set aside more than you need than to end up short when it’s time to pay.

Another best practice that will help mitigate the sting of paying taxes directly is to determine your estimated tax.  There are two types of taxes you’ll be paying as a self-employed employer.  The first is a self-employment tax, the sole purpose of which is to cover your Medicare and Social Security taxes.

When you work as someone else’s employee, the employer pays half of this tax, but when you’re self-employed, you’re responsible for paying the full amount.  The tax rate on this will likely fluctuate from year to year, but you can expect to pay about 15% of your earnings, give or take a little, as self-employment taxes.

The second type of tax you’ll be paying is income tax on whatever profits your business earns.  This can be calculated by determining your net income, which is your total revenue earned (that’s your gross income) and subtracting all deductions and business expenses.  In the event your expenses exceed your income, which isn’t uncommon in your first year, you will be able to deduct a net loss that year.

But if your business nets a profit, you’ll pay income tax on your income just like you did when you worked for someone else.  That’s why it’s best to err on the side of caution and get into the habit of putting 25-30% of your income in your business savings account for taxes.

If you expect to owe the IRS a minimum of $1,000 in taxes this year, you’ll need to estimate your taxes owed and pay the IRS each quarter.  The IRS website has detailed information about Schedule SE (Form 1040) and all you need about to know about the self-employment tax and of course, your accountant will help you with the execution of your quarterly tax payments.

If your business is set up as an LLC, your can find helpful tax information on the IRS website for Single Member Limited Liability Companies and LLC Filing as a Corporation or Partnership.

Protecting Yourself

Working for yourself has rewards, challenges, and considerations that are unique to the self-employed. One area in which you’ll need to invest some time and research is in the are of self-protection.  Specifically, you’ll want to do your due diligence and make sure you’re insured to provide maximum protection.

There are several types of insurance you might review to determine what’s best for your new busines.  Professional Liability Insurance, also sometimes called Errors and Omissions insurance, covers you if a customer or client alleges you were in some way negligent while doing contracted work for them. 

General Liability Insurance can provide protection against costs connected to property damage, bodily injury, and third-party accidents.  Workers Compensation Insurance is required by some states if you have employees, whether they are part-time or full time.  It provides protection against financial expenses you might incur if an employee is injured or becomes sick while on your clock.

Set up a meeting with your insurance provider, or one that specializes in business insurance policies, and let a professional help you choose the protection that makes the most sense for the type of services or products you’re offering.

Health insurance might be top of mind for you if you’re not already covered.  Needs in this area vary greatly based on a number of personal and professional factors, so set aside money in your budget to secure some type of medical plan if needed.

The final way you’ll need to protect yourself is by planning for your future.  If you are coming from an employment experience in which you had automatic contributions deposited into your 401(k) account, perhaps matched by your employer, you will now need to take on the responsibility of saving for your future.

Meet with a financial planner to talk through the pros and cons of solo 401(k) plans, traditional Simplified Employee Pension Plans (SEP-IRAs), and Roth Individual Retirement Accounts (IRAs).  You’ll never regret investing in your retirement and establishing a long term savings strategy right from the launch of your new business will provide peace of mind so you can focus on growing your business.

There is much to learn when you’re newly self-employed, so make friends with the idea of being a student while beginning to run your own business.  Learn as much as you can about the tax laws, insurance needs, and bookkeeping practices that will be part of your daily life and reach out to the appropriate experts to help you get off to a good start and stay on track.