Episode 214: From Employee to Entrepreneur: Key Considerations

Hey everybody, this is David Chudick and welcome to this week's episode of the Weekly Wealth Podcast.

Today I want to talk about some of the things that you might need to be thinking about if you are looking at being a freelancer, if you are looking at being in the gig economy, or if you're looking at being self employed.

So we're going to talk a little bit about the differences between having a W2 job and being self employed or being an independent contractor.

So I know that there are a lot of people that maybe don't have a great understanding of these differences and that can lead to some pretty major consequences during tax time.

So I hope that you enjoy this episode.

Welcome to the Weekly Wealth Podcast.

I am certified financial planner David Chudick.

This podcast and my wealth management practice are both designed to help the mass affluent to live better lives by how.

They handle their money.

We talk about financial strategies, prosperous mindsets, and simply how to build true wealth.

So come on and let's enjoy this journey together.

Have you ever thought about going out on your own?

Have you ever thought about maybe doing some freelancing or being part of the gig economy?

If you have, this is going to be an exciting episode of the weekly wealth podcast for you.

But before we dive into the meat of the show, let's make sure that we do all the things.

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All right, so today we're talking about some different considerations that you might have if you're thinking about either not having a W2 employment position or if you're thinking about leaving your W2 employment position and going out on your own.

So let's first talk a little bit about some of the differences between being an employee and being an independent contractor or somebody who works for yourself.

So in an employment situation, your employer has direct control over how work is done.

Your employer has direct control over when work is done.

So your employer makes your schedule, says you have to work from 9 until 5 or you have to be in by 10am and they have control over that schedule.

Your employer might provide specific training, office space, equipment, et cetera for you to do your job.

Your employer will pay you some regular hourly wages or salaries.

The employer is also responsible to withhold taxes and the other deductions.

When you're an employee situation, employees generally have very few expenses, so they don't pay much of anything.

And if they do, they are oftentimes getting reimbursed for travel and things like that.

And really, generally speaking, employees have direct supervision over their employees.

So in an employer employee scenario scenario, the employer has a high degree of control over the employee.

So some of the benefits for the employer is that yes, they have that control.

Some of the benefits for the employee is that they have very little expenses.

They don't have really any risk of losing money.

But then they are controlled fairly closely by the employer.

Now let's look at maybe you decide you want to become a consultant or maybe you want to be an independent contractor and work for yourself.

And some refer to this as the gig economy.

So the independent contractor has much more control over how they perform their duties.

The independent contractor might perform work for numerous organizations.

When you work for a company as an employee, oftentimes they will make it to where it's against their policy for you to work at another company, the independent contractor.

And this is crucial and we'll get into some more details, but they are responsible for payroll taxes, et cetera.

So let me say that again.

If you're an independent contractor, if you're a freelancer, if you're self employed, you have to take care of your own payroll taxes.

Your independent contractors of the world, they have increased legal liabilities.

They may have higher earning potential, but they also have the potential to actually lose money.

Gigs and project work and things like that are normally temporary in nature.

And of course your independent contractor, self employed type person, they will actually have expenses.

We'll talk about some of the typical expenses in just a moment.

But that sums up kind of the difference between an employee, which sometimes is referred to as a W2er, and a gig independent contractor, which sometimes is referred to as a 1099er because that's the form that they receive at the end of the year.

So the first thing I'd like to talk about is a gig dollar or a self employment dollar is not equal to a paycheck dollar.

So what do that?

I'm going to take an example of $100,000 per year salary.

Now these are going to be round numbers, but you'll get my point because these will vary based on State.

But $100,000 salary divided by 24 paychecks would be about 4,166 per month.

So if you have $100,000 salary, your every other week paycheck should be $4,166.

Now of that probably about $600, depending on your dependents and so on, would be withheld for income tax, federal income tax.

Okay.

Now you would also have $258.33 withheld for your Social Security and $60.42 withheld from Medicare.

Now of course, on both of those, the employer matches it, so they're putting in that portion for you.

In this case, you might have maybe $200 withheld for your state income taxes.

So before we look at any 401k, any retirement plans, anything like that, your take home pay on your $4,166 paycheck is probably going to be around $2,729.

Okay, so let's go over those numbers again.

Your salary amount was about $4,166 and you're end about $2,729.

And that's before having a 401k or any voluntary benefits taken out.

Now if you are doing a project for me on a freelance basis and if we agree that I'm going to pay you $4,166, then at the completion of that project or based on the terms of that project, I would write you a check for $4,166.

And now guess what?

That's how much money you received.

Now does that mean you don't have to pay taxes on the money?

No.

On the contrary, you are going to need to pay taxes on that money.

Does that mean that you don't have to pay Social Security and Medicare?

Nope, you actually do.

So these are things that you would be required to pay yourself.

They're not withheld from your fees.

So that is one huge difference between being an employee and being an independent contractor.

So if you're not careful, you might have gotten that $4,166 check as a freelancer and you spent it all because maybe this is your first year and you didn't realize you were going to have payroll taxes.

You didn't realize you were going to need to withhold federal and state taxes because you're going to get a tax bill at the end of the year.

So first thing to remember is that a dollar of net paycheck is much different than a fee that you might receive as an independent contractor.

So make sure that you're consulting a tax professional, but you're going to be responsible to Pay the full 15.3 Social Security and Medicare via IRS website EFTPs.

Since there will be no taxes withheld from your fees, you're going to have to pay quarterly taxes.

And then if you don't do these two things, you will be miserable when you file your tax return in the following year because you'll have some penalties, you'll have some fees, and you'll actually owe those taxes.

Now another thing to remember if you are an independent contractor is you can typically deduct business expenses from your gross income.

So let's go back to that previous example of $4,166 that you received for completing a project.

Well, you may have had some gas expense, you may have had to buy some equipment, you may have had to travel, you may have had to do advertising in order to get that job.

So those are all expenses that you would talk to your tax professional about and you can deduct those and you can have an actual lower profit.

So just remember that all of the monies that you receive as an independent contractor are not yours to keep.

And in many cases it actually had a cost in order to get.

So working with a tax professional becomes crucial if you are an independent contractor, if you're a sole proprietor, or if you're self employed.

Now another factor to consider if you are in one of these positions is how do you plan for irregular cash flow if you have a job, if you work hourly, if you have a salary, you pretty much know how much your paycheck is going to be.

And none of our paychecks are ever big enough, but at least you would know what it is.

But as an independent contractor, you might not have a steady salary.

You might have periods of high income and periods of low income or even no income.

And you might even even have expenses during these periods of no income.

So you have to plan on how to plan for irregular cash flows.

As an independent contractor, this is crucial and you need to put yourself on a pretty tight budget until you have a good idea on how much money is typically going to be coming in.

Now, some other considerations and things for you to think about as a freelancer, as a self employed person, are you going to operate as a sole proprietor or are you going to form a business entity, maybe an LLC or a corporation?

Now, we don't have time to go through the positives and negatives of each and this would be something.

If you have a question, you can email me davidfinancial.com or you can talk to your own accountant or attorney, but oftentimes it is in your benefit to form an entity who will draft and review your agreements.

So now that you're on your own, you don't have a legal department of the big corporation that you work for.

So you may have to end up paying an attorney to draft or review your agreements.

That's an expense.

That's something that you did not have to do when you were an employee who will handle your bookkeeping, your accounting and your withholdings.

These are things that you can do yourself or you can hire a professional.

I always err on the side of hiring a professional to make sure that these kind of things get right.

Now, what about your retirement plan and your investment plan?

If you were an employee of a corporation, more than likely you would have had a 401k or some sort of retirement plan available to you.

Now that you're on your own, you might have to form your own plan.

So you want to consult a financial advisor, you want to do some research on your own.

There are some differences between simple IRAs, SEP IRAs, 401ks, things like that.

But you don't want to put those decisions off because as the clock ticks and as the years pass away, you are losing the power of compounding interest if you don't put an investing plan in place.

And remember, here's a big thing.

This is a legal and administrative consideration.

If you're let go, if you're fired without cause from a job, oftentimes you can qualify for unemployment payments and get some income.

Now if you are a sole proprietor or if you're an independent contractor, you are not eligible for unemployment if it doesn't work out.

So this makes it crucially important for you to have an emergency fund and to be dealing well with your personal finances.

Now another factor, and we're going to talk about liability and we're going to talk a little bit about laws.

But remember, I am not an attorney.

I'm giving very general information.

So if you have any questions, make sure you talk to a licensed attorney in your state.

But as an employee, your employer is generally responsible for your mistakes and your errors.

As an independent contractor, you need to develop a risk management program.

So when we're talking about risk management, we're typically talking about either self insuring or we're talking about transferring risk to an insurance company by purchasing an insurance policy.

And some of the types of insurance policies that you might consider having are general liability.

Now this is a type of business insurance that protects you if someone claims you cause them Bodily injury, property damage, or personal injury.

An example of personal injury would be like libel or slander while you are performing your work.

Now, if you work for a company, if you're an employee, they are typically going to have general liability.

But now that you're on your own, you might need to have this yourself.

Another type of insurance that you might consider having would be errors and omission insurance, and that's known as E and O.

And that's a type of professional liability insurance that protects you if a client claims that you made a mistake, were negligent, or failed to deliver your professional services as promised.

So that's errors and omissions insurance.

And that can be somewhat costly, but it can be very necessary as well.

Now, if you have valuable equipment, you might want to cover it, or it might even be required to be covered if you have a loan on it through a commercial property policy.

Okay?

So if you have equipment, commercial property might be something that you would consider having.

And then finally, and this one's a little bit counterintuitive, but workers compensation, even though you might not have any employees, your client that you're performing work for might require that you have workers compensation insurance as a condition of working for them.

So workers compensation also can have a relatively significant cost.

And these are things that you might need to build into your prices.

Now, if you work for a big company, oftentimes they are providing training.

They might be paying for your certifications.

They might have a training department, they may have a personal development department.

But if you are on your own, if you're an independent contractor, if you're a sole proprietor, you need to be providing these things for yourself.

So if you're in a profession where there are certifications, you will be, that'll be your responsibility, and that'll be your expense.

And that can be a significant expense depending on who you are or where you are.

In my industry, I have to pay for my continuing education and my license and fees and things like that.

And that can all add up.

So make sure that you understand that you are the training department and you have to pay for the training department.

And that's part of being out on your own, and that's part of the risk that we take.

So let me give you some closing thoughts.

Make sure that you're developing a good relationship with a tax professional or cpa.

These are things, when you're looking at how to handle your commissions, how to handle your 1099 payments, that really need to be done right.

And there are a lot of mistakes that can be made need.

Let's make sure that we're setting aside tax payments from each source of revenue.

So every time you're getting some money coming in, let's put some of that away for taxes.

Let's make sure that we are building an emergency fund both for the business and personally.

Just because you completed a project for a client doesn't mean that you're getting paid for it tomorrow.

You may have to wait a little while before getting paid.

And guess what?

Sometimes clients don't pay their bills.

That's just part of being in business.

So sometimes you'll do work and not get paid for it.

And that's why you need an emergency emergency fund so that you can still pay your personal expenses.

If that happens, let's make very sure that we are building a personal budget and let's live below our means until our profit is very high.

So again, cash flows might be uneven.

And let's make sure that we're living below our means and living on a fairly strict spending plan until we have a regular stream of profit.

Now let's make a mental distinction between revenue and profit.

So going back to our example of that $4,166 check that we received as a freelancer, that is revenue, that is not profit.

You may have had to purchase equipment, you may have had expenses associated with that.

And when you take your income minus your expenses, that equals profit.

So let's make a mental distinction between revenue and profit.

Sometimes a job that brings in more revenue may not bring in as profit as a job that brought in less revenue.

So let's get profit on the forefront as much as possible.

Let's make sure to build our networks.

So your net worth is your network.

It's who you know and who knows you that can help you to get into doors that you might not be able to get in on your own.

And then finally, when you're in a self employed type scenario, you really have to have like this, that failure is not an option attitude.

You have to say, I am just going to have to figure out how to get it done because I don't have a salary, I don't have a guaranteed hourly wage, so I need to just figure out how to solve the problems that I need to solve and just make it work.

What do you think?

Would you rather have a guaranteed salary or would you rather have unlimited upside earning potential but also have expenses and have the risk that at times you might not have a lot of cash flow coming in?

This is a fascinating psychological study and it's interesting to see different people's perspective on that scenario.

Now, as you know, I love the business owners and what we've in essence been talking about is the beginning stages of business ownership.

If you are a business owner, make sure that you're emailing me or make sure that you're going to my website, my exit planning website, www.allofmyassets.com and take the value builder questionnair.

It'll give you a range of value of what your business might sell for and it can help you to understand some of the areas that you can improve so that your business will become more sellable.

And even if you don't plan on selling your business right now, a sellable business is a more profitable business and a more fun business to run.

So you will simply have an easier life today.

All right, everybody, so don't forget to check out our social media.

Let me know if you have any questions.

Email me david@parallelfinancial.com and until next episode, I wish everyone a blessed week.

Thanks everybody.

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