According to the Pew Research Center, Millennials became the largest generation in the labor force in 2016. Reading through this data, I was initially surprised by the number of Millennials that have chosen to pursue self-employment, rather than a more traditional career path. However, once I thought it over a bit, I realized that I know more than a few self-employed people – including my brother, Christopher!
Chris started his first company in 2011. He was a senior in college and looking to make a little extra money before he graduated and entered the work force. Like most of us, he applied for many 9-5 jobs during his senior year, not anticipating that his side project would launch his entrepreneurial mindset. Fast forward seven years and I have seen him develop his web design company, launch a successful IT firm, and grow a family owned real estate company.
As his sister, I was extremely proud of him and his accomplishments. However, the financial planner in me was champing at the bit to make sure he was setting himself up for success. One day, I decided it was time to give him my 2-cents so I put together a list of planning items that he should review as an entrepreneur. While at first he laughed, he appreciated my input and recognized the importance of implementing some fundamental steps in order to be prepared.
So, what are a few items the young entrepreneur should be thinking about, exactly? Let’s break it down.
The importance of having a financial cushion in place is a well-known concept. That cushion becomes even more critical when you are self-employed and have irregular cash flows. However, irregular income can make building an emergency fund seem daunting.
While the general rule of thumb is to have between 3 and 6 months of expenses stashed away for emergencies, don’t allow that number to intimidate you. Slowly build up your emergency fund by setting realistic short-term goals and putting aside any cash you can spare.
Saving for retirement can be considered more difficult for a self-employed individual than a traditional, W-2 employee. While a W-2 employee does need to determine upfront what they wish to contribute to their 401(k) plan, once they decide on an amount, any contributions are taken out of their pay check and put directly into their employer’s retirement plan. Additionally, W-2 employees may be offered matching contributions from their employer.
A self-employed individual has to take the initiative to ensure that they are saving for retirement. This means opening a retirement account on their own and making a conscious effort to contribute money to it. There are a few different retirement options that self-employed individuals can take advantage of (e.g. SEP IRA, Solo 401k, Traditional or Roth IRA, Simple IRA, etc.). Each type of account has its own benefits, so it may be beneficial to work with a CPA or financial advisor to choose the right option for your business and financial life. As for contributing to a retirement plan, I always recommend setting up automatic contributions from a checking account. Doing so will take the thought process out of saving.
When someone is young and just starting out, they most likely do not have many assets that need to be protected. Therefore, the most important asset they have to protect is their own ability to earn income. That’s where disability insurance comes into play.
Unlike a W-2 employee, who most likely receives disability insurance through their employer, a self-employed individual will need to purchase their own disability insurance. Most insurance companies will cover up to 60% of your income in order to incentivize anyone on disability to go back to work once they are able to.
Young professionals building their businesses should also consider adding a Future Increase Rider (also known as the Future Increase Option or FIO) to their disability plan. A rider is a provision of an insurance policy that allows the insured to amend the coverage or terms of their policy. The FIO rider allows an entrepreneur to purchase sufficient disability insurance based on their current income, but guarantees them the ability to increase coverage as their income grows without having to jump through any additional hoops – like answering health questions or undergoing medical exams.
Planning for Taxes
One of the biggest changes a self-employed individual will need to consider is how they pay taxes. Unlike a W-2 employee who can rely on their employer to process any payroll taxes on their behalf, a self-employed individual must be proactive in withholding the amount they will owe for their taxes. Their income tax, as well as self-employment tax will need to be taken into consideration. Self-employment taxes cover Social Security and Medicare taxes which are usually split between employers and employees. Creating a separate bank account that can be used to set aside money for taxes would be beneficial when it comes time to pay quarterly taxes and could make filing your tax return less stressful.
There are many advantages to being self-employed. Between flexibility in your work life and unlimited potential income, the list of benefits is extensive. However, if you are going to go the entrepreneurial route, start your business off right and implement a few strategic financial tips that will ensure your success as your business grows!