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Want to Be Self-Employed? These 2 "Hidden Taxes" Will Cost You Thousands

By Jason Hall – Mar 10, 2019 at 9:01AM

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The portion of Social Security tax employers pay and employer-matching contributions to retirement accounts really add up.

One of the most powerfully rewarding decisions I ever made was to walk away from my job and to become a contract writer for The Motley Fool. It's been more than five years since making that change, and I could burn a few thousand words describing how it's improved the quality of my life and given me more professional fulfillment. 

Instead, let me caution readers considering making the move to avoid some common pitfalls, including not considering the full implications of going to work for yourself. There are things you'll be responsible for paying for that your employer covers today, and it could have a significant impact on how much money you actually keep -- not to mention how much tax you owe -- when you're self employed. 

That's why, even though my experience has been wonderful, and I can't imagine ever going back to employment-based work again, it's not for everyone. 

A young man in an office conference room smiles as he carries his office belongings in a box, preparing to walk out.

Going to work for yourself can be rewarding if you avoid the hidden pitfalls. Image source: Getty Images.

Case in point: There are two simple items your employer pays for today that, between them, could cut the amount of your earnings you take home by 10% or more when you're self-employed. Let's take a closer look at them, as well as some strategies to lessen the impact. 

The other half of the Social Security tax

If you've ever collected a paycheck, you've seen the Social Security Taxes line (or FICA) on your pay stub or W2. Employees pay 6.2% of their earnings in Social Security tax each year, capped at a certain amount of income. In 2018, it was 6.2% on the first 128,400 earned, but that amount increased to $132,900 in 2019.

Of course, you would continue to be responsible for Social Security tax if you're self-employed. But what many people don't realize is the payroll withholding you see on your pay stub is only half of the total that goes to Social Security. Your employer pays another tax, equal to 6.2% of your earnings, in Social Security tax. 

Woman with stunned expression looks at computer screen.

Don't get caught off guard by the self-employment tax. Image source: Getty Images.

When you go out on your own, your Social Security tax burden doubles from 6.2% to 12.4% of the first $132,900 you earn. When you add in the 1.45% Medicare tax -- also paid by the employee and employer --  your combined FICA tax rate goes from 7.65% to 15.3%. 

Called the self-employment tax, this higher rate works out to an additional $765 in taxes you'll pay on every $10,000 you earn, up to the taxable earnings limit. 

Something else your employer pays 

While it's not an actual tax, there's another substantial amount of money that most employers give workers each year, that you'll need to offset: 401(k) employer contributions. 

According to Vanguard, which manages more than $5 trillion in assets for millions of American workers through thousands of employer-based retirement plans and individual accounts, the average employer gives workers a substantial amount of money each year toward retirement. 

401K plan statement with ink pen.

Don't forget to account for money your employer gives you toward retirement savings. Image source: Getty Images.

According to the 2018 edition of Vanguard's annual report How America Saves, the average Vanguard employer-sponsored plan matched 4.2% of pay in retirement account contributions, while the median value was 4% of pay. More than half of plans Vanguard manages actually match 5% or more of pay. 

And while you don't see these contributions on your paycheck since they go into your retirement account, it's very real money that you will walk away from when you're self-employed. If you don't replace it, you'll pay the price with less saved when you retire. 

Good news: These tax breaks can help make up the difference

Between the other half of payroll tax you'll become responsible for, and the lost retirement account contributions, the average self-employed person will need to come up with almost 12% more income to simply break even if nothing about your tax situation changes. However, there's some good news on the tax front that can help lessen the burden of increased tax obligations and lost benefits. 

First, there are likely a number of tax breaks you will qualify for when you become self-employed:

  • Business travel expenses and mileage.
  • Health insurance premiums.
  • Home office deduction.
  • Child and Dependent Care tax credit.

In addition, there are two tax breaks related to the self-employment tax and retirement savings contributions. First, you get to take a deduction for half of your self-employment tax from your taxable income, so the effective rate you'd pay ends up being less than 15.3%.

Second, those employer contributions to your retirement savings didn't give you a tax break, but they can cut your tax bill when you're self-employed. Any contributions you make to your 401(k) -- up to $56,000 ($62,000 if you're 50 or older) -- would earn you a tax deduction when you're self-employed. This will help offset the additional expense, and there are a number of low-cost online brokers which offer 401(k) plans for self-employed folks. 

Set yourself up for success

Being self-employed might be the best career move you ever make. But it can also lead to financial hardship if you don't take into account things that your employer may be paying for today that will fall on your shoulders going forward. 

So before you make the jump, it might be worth meeting with a tax professional in your area who specializes in self-employed clients. This can help you avoid common pitfalls, while also setting you up with better expectations. 

Making sure that you're prepared for all the financial implications of being self-employed will make a huge difference in your success. If you do make the move, I wish you the best of success, and if you're anything like me, you'll never, ever look back. 

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