This is the third part of an ongoing series on going independent. The aim of these blog entries is not to convince one to stike out on their own, nor is it to encourage one to stay employed. It's merely some food for thought for those considering the transition... Part 1 talked about the pros and cons of being employed vs. being self-employed. Part 2 looked at some of the first steps that one needs to take to go independent. This part will examine tax issues surrounding self-employment.
Here's a riddle: what is the one question you could ask someone to determine if they were self-employed or not (short of asking them directly)?
The answer: Do you think taxes are too high? If you get a ho-hum answer, chances are the person is employed. If the person begins foaming at the mouth and goes on a 20 minute diatribe on taxes, you can bet the person is self-employed. Here's another possible question to ask: How much did you pay in taxes last year? If they don't recall, I'd bet dollars to donuts that they're employed.
Typically employed individuals don't have such a resentment toward taxes because their tax bill is collected for them by their employer before they receive their paycheck. As an employee, your employer withholds a certain percentage of your paycheck each pay period. Once a quarter, your employer sends a big check to the Federal and State governments. At the end of the year, when you fill out your taxes, your amount due is your tax burden less what you have already paid in. Some people naively get excited when they get a "refund" on their taxes - this just means you paid in more than you had to, in essence giving the government an interest-free loan.
When you work for yourself, you are your employer, so you are the one who sends the quarterly checks into the government. For those first making the switch from the employed world to the self-employed world, this process can be a bit of an eye opener. Four times a year you have to sit down and write both the Federal and State government a check. Make sure you have a good estimate of your income and make these payments accurately. If you overestimate, you're giving an interest-free loan to the government. If you underestimate, you have to pay a percentage based on the underestimation. (That is, if you underestimated by, say, $10,000, you might owe the government $10,250 - a $250 penalty for underpaying them during the year).
Additionally, there is employement tax. As an employee you pay income tax and social security / medicare. Your employer pays employment tax. (This is why companies like to hire contractors. As contractors they are not employees, so they don't have to pay them benefits or pay employment tax.) When you work for yourself you must pay self-employment tax. See http://www.irs.gov/businesses/small/article/0,,id=98846,00.html for more info. To quote:
Who Must Pay Self-Employment Tax
You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.
- Your net earnings from self-employment (excluding church employee income ) were $400 or more.
- You had church employee income of $108.28 or more.
The big difference in taxes between employed individuals and self-employed individuals, in my opinion, is a psychological one. As an employer, the tax withholdings are nicely taken from your paycheck automatically. It's not like you get paid $x and then have to write a check to Uncle Sam for $x/3. But being self-employed, you have to. Five times a year. (Once every quarter, and once by April 15 if you've not paid enough.) If you're at all like me, it will raise the blood a bit, because you will realize how much you are paying into the system, while others - your employed friends - don't seem to grasp it because their taxes are discretely taken out of their bimonthly paychecks, so they don't see it add up like you do. Furthermore, they aren't burdened by self-employment tax. Furthermore, their company provides health insurance and a retirement plan - those responsibilities are on your butt when you're independent.
The point is, as an employee you kind of live in an "ignorant, but bliss" world. As an independent, you see where every dollar goes - $x to Uncle Sam; $y to health/dental insurance; $z to retirement plan; etc. This is nice in that it breeds efficacy and fiscal awareness, but can be a bit disturbing when transitioning from employed status to independent status. It's like the Matrix - once you take the independent pill, you can't go back. Even if you do return to the employed world, you'll have a better understanding of how much things cost.