How to Effectively Transition from Full-Time to Self-Employed

At last count, nearly 10 million people were self-employed and another 6 million were working gig jobs, according to the federal Bureau of Labor Statistics.

BLS had already projected those numbers would grow. But with 40 million people losing their jobs during the COVID-19 pandemic, it’s likely even more people will turn to consulting, freelancing or gig jobs to make ends meet.

And whether you’re a gig worker providing ride share services or food delivery, consulting as an engineer or analyst or freelancing as a writer or editor, from a wage, tax and benefit position, you’re essentially self-employed.

For those new to that classification, the financial considerations can be a real eye opener, warns Mackey McNeill, CPA/PFS and member of the AICPA Consumer Financial Education Advocates.

“A lot of people move from being employed to working for themselves,” she said. “But just because they’re self-employed doesn’t mean they’re not running a true business. They need to change their mindset.”

Compensation and hourly rates

The first issue the newly self-employed need to address is the rates they charge and the compensation they need. This can be challenging. For most salaried, full-time workers, it’s easy to determine their hourly rate: simply divide gross income by 2080 – the average of 40 hours a week times 52 weeks. So, if you’re grossing $104,000 a year, that works out to about $50 an hour.

But if you charge $50 per hour as a self-employed individual, you’ll likely see a lot less than $104,000 come in.

“Once you add in paid time off, health insurance, retirement savings, disability benefits…. you’re at a 50% pay cut,” McNeill said.

Gross salary for most full-time employees is only a portion of their total compensation. Employers routinely cover a portion of the health insurance and disability benefits of employees, as well as contribute to retirement plans. At the same time, paid time off allows you to continue earning income when not generating revenue for the company.

Once you’re self-employed, the full cost for those benefits is on you. So, you need to determine those costs before setting your billable rate to assure you can cover those expenses and still generate your needed level of income.

Billable hours

Based on the 40-hour work week, there are exactly 2080 billable hours a year. But don’t count on being able to bill for all of that, McNeill warns.

“Don’t plan on billing more than 1,000 hours,” she said. “After you spend your time finding clients, marketing, managing invoices and billing, you really don’t have more than 1,000, maybe 1,500 hours, of billable time.”

Large companies typically employ sales, marketing, accounting and human resources departments that promote services, find clients, manage invoicing, collect payment and pay taxes, among other things. This allows employees to specialize in their area.

As a self-employed individual, all those tasks are up to you, and they take time.

McNeill said it’s important to consider how many billable hours you realistically have when determining your rates.

Tax Time

Yes, the tax man comes for everyone. For most full-time employees, their employer takes care of paying on their behalf their income tax withholding as well as Medicare and Social Security. Self-Employed workers must pay that too.

But many fail to plan for self-employment tax, says McNeill.

“Many newly self-employed individuals finish the year and think, ‘Wow, this is great. I made $50,000. I used to only make $45,000.’ Then they find out about their 15.3% self-employment tax and wonder how they are going to pay that $7,650,” she said.

McNeill warns those who are self-employed to be sure to consider those tax ramifications in their business plans.

At the same time, she notes that there are some tax savings for the self-employed. Schedule C allows you to deduct business expenses, such as your car, utilities, software services, and even your home office. Just be careful that you limit your deductions to actual business expenses.

This means that you can deduct the mileage or actual cost of driving your car to a client appointment or if running a ride share. For those who drive a lot, McNeill recommends purchasing a very inexpensive car and using the mileage deduction (currently 57.5 cents), which is often more than the actual cost.

Things get more complicated when deducting for a home office. First, the IRS requires that your home office be exclusively dedicated to your business and not serve a dual purpose.

“You can’t just have a play room with a desk in it,” said McNeill. “If you work in your dining room, but then eat family dinner there, that’s not an exclusive home office.”

If you meet that requirement, the IRS allows a standard $5 per square foot deduction up to 300 square feet. Or you can deduct the actual cost as a percentage of your homeownership. IRS Form 8829 can help you determine which deduction is larger.

Software necessary for your job is easily deducted, but things like utilities can be more complicated. If you have separate internet or phone lines for your business, that is fully deductible. But if you share Internet or phone lines for personal and business use, you can only deduct the percentage of that bill that is business related. A CPA can help you determine those percentages and identify which expenses are truly deductible.

Tips for success

Despite the challenges those transitioning from being full-time employed to being self-employed face, there are many things you can do to make it easier.

“If you want to be successful, you need to implement structures around your new business,” said McNeill. “Standardize your accounting processes, set up your books, build a business plan, determine how many hours you can work.”

First, McNeill advises creating separate accounts for your business and personal expenses. This will make it easier to track all business income and expenses for tax purposes and assure your personal and business interests are not mixed.

Next, she says it’s important to build a plan. A CPA can help you build that plan and establish your accounting processes, structures and reporting. They can also help you address your available hours and create realistic billable rates.

Then comes tax planning. Your business may be just starting, but you need to know what your tax bills will be and be sure to plan to cover that bill when it’s due.

Tax planning is particularly important for people who are working side gigs or freelancing in addition to a full-time position. They will still have to pay Medicare taxes on those earnings and the rest will be taxed at the incremental rate.

“Will that extra income bump you up to another tax bracket costing you more than you’re making?” said McNeill. “If so, you may want to reconsider whether it’s worth your time to freelance on the side.”

Once you have the structures and plans in place, it is much easier to begin contacting potential clients, marketing your services and building a successful enterprise.