If you are considering going out on your own, or you’re already your own boss, you are part of a growing trend. Roughly 64.6 million Americans reported some degree of self-employment in 2022.1
If you take this big step, don’t overlook that some important perks of a traditional job—such as retirement savings plans and insurance—will no longer be provided to you. But because these could be key components of your long-term security, neglecting them could cause you hardship down the line that may diminish the joy and success of your self-employed lifestyle.
Fortunately, they are not hard to put in place. We think enjoying both freedom and long-term financial security while being self-employed comes down to three key areas.
Long-term financial security hinges on planning for your wealth later in life, including Social Security, retirement savings, and insurance protection. Here are the ins and outs of each.
In traditional jobs, the employer and employee each pay 6.2% of the employee’s net income into Social Security and 1.45% into Medicare. This is taken from each paycheck before it comes to an employee. Assuming working individuals make 10 years of these payments (40 quarters), they’ll receive Social Security checks in retirement based on their contributions.
But how does it work for self-employed people?
If you continue to pay into the system (and make at least 40 quarters of payments in your lifetime), you will receive checks based on your highest 35 years of reported wages.
But since you are now your own employer, you need to make the payments on your own (instead of having them automatically withdrawn from your paycheck). Many self-employed people do this at the end of the year—in their tax returns—instead of with each paycheck. This is fine but requires a bigger payout all at once, so consider paying more often if you want to budget better.
Another difference is, that self-employed workers must pay both the employer’s and employee’s portion, or 15.3% of taxable income. The employer’s portion is a deductible expense, somewhat lowering this cost.
Remember an important tradeoff: While the self-employed are often encouraged to claim every business expense possible to lessen taxable income each year, this also reduces your Social Security payment later in life. Should you report fewer expenses now to get more benefits later? It’s hard to calculate, but the benefit of doing this is greater for those with lower incomes than those with higher incomes.2
Another big change when self-employed is funding your retirement.
In a traditional job, many employers offer a retirement plan that automatically takes pre-tax contributions from workers’ paychecks. They may also provide a matching contribution.
Now that you are self-employed, you need to do this yourself. Our advice—don’t stop contributing! You can set up your own plan or contribute to various retirement accounts. Here are a few to consider:
However you decide to save for retirement as a self-employed individual, it’s important not to delay doing so. Delaying even a few years can result in much lower retirement savings later due to a loss of long-term compounding. For example, if you fail to contribute even as little as $5,000 per year into a diversified stock portfolio earning 7% a year from ages 28 through 33, you could give up the opportunity to amass over $200,000 30 years later.4
Well, like Hannah Montana sang, “You’ve got the best of both worlds!” You can still contribute up to the max of your employer-sponsored retirement plan (like a 401(k)) and your own business’ 401(k), simple IRA, or SEP plan. For example, if you are under the age of 50, you can contribute $22,500 to your employer 401(k) and 25% of your net earnings from self-employment up to $66,000 for your SEP plan for 2023. (There are restrictions like you cannot be an owner of your employer’s business, so consult with a tax professional.)
Another aspect of your long-term security that changes with self-employment is insurance. In traditional jobs, many employers provide health and sometimes life insurance. When you’re self-employed, you need to get these for yourself.
Don’t underestimate the importance of insurance. It’s protection against an emergency that could result in financial ruin but, more importantly, hurt your health and well-being.
There are many options for health insurance, from low to high deductibles, and even plans that allow you to save more in a Health Savings Account. Consult an insurance broker or your state’s health insurance marketplace via healthcare.gov to help you make the choice that best fits your circumstances. As a bonus for self-employed individuals, costs associated with health insurance premiums for yourself, your spouse, and your dependents are considered tax-deductible expenses.
Life insurance is another important consideration for a self-employed person. If you don’t have dependents, you may not need it. But if you do, we believe it’s important to have a mechanism for replacing your income in case of premature death. There are a lot of ins and outs of life insurance, so consult with an insurance professional to learn more about your options.