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Financial Literacy for Self-Employed Folks

In celebration of financial literacy month, here's what self-employed folks should know about managing their money.

Photo by Samson Katt on Pexels

When you work for yourself, and while the main tenets of personal finance remain — save, spend, invest, and protect — being self-employed comes with it a host of different challenges. For instance, you'll need to manage money on an inconsistent income, pay for your own health insurance, and get your head around different retirement savings options.

As I near my 8th full year of self-employment, here's what I wish I had known about managing my finances as a small business owner, freelancer, and gig economy worker:

Understand the Importance of a Buffer Fund

Because freelancing is prone to feast-or-famine cycles, and in turn inconsistent income, you'll want to have a buffer fund to tide you over during those lean months. What's the difference between a buffer fund versus a rainy-day fund? While a rainy-day fund, or emergency fund, is intended for true emergencies, a buffer fund is money you can tap into to cover living expenses if you're experiencing a gap in cash-flow.

While advice like this might prompt an eye roll and have you thinking: How can I possibly set aside money for a buffer fund when you're struggling to cover bills? There are tactics you can employ to save on variable income. For instance, save a percentage of your earnings after monthly expenses are covered, a portion of your tax refund, or stash cash during higher-income months.

Know Your Tax Responsibility

When you work for yourself, you'll need to pay for your own self-employment tax, or FICA (Federal Insurance Contributions Act), which is made up of Social Security and Medicare taxes. The current rate for 2022 is 15.3%, which is 12.4% for Social Security, and 2.9% for Medicare. When you work for someone else, your employer pays half of those taxes, while you're responsible for the remaining half. But when you are self-employed, you're on the hook for the entire amount.

Besides self-employment tax, you're also responsible for paying quarterly taxes. How much you owe in taxes each year depends on a handful of factors, such as your marital status, number of dependents, tax bracket, income, deductions, and credits. In turn, how much you'll need to set aside varies. A general rule of thumb is to save anywhere from 25% to 30% of the money you earn.

Chances are, you won't need to tap into that entire savings to pay Uncle Sam. That's because tax deductions will lower how much you owe. But it's better to have that money set aside until you've filed your tax returns.

Create a Business Budget

Besides coming up with a personal budget when you're on a variable income, you'll need a business budget. A business budget typically includes expenses such as:

  • Accounting and productivity software
  • Office supplies, and equipment necessary to run your business
  • Health insurance
  • Disability insurance
  • HSA contributions
  • Cell phone and Internet
  • Advertising and marketing expenses (i.e., web hosting)
  • Car expenses (if you use your car for work)
  • Co-working membership
  • Work conferences
  • Meals and entertainment for work
  • Any other expenses necessary to run your business

Think of Health Insurance as Multi-Pronged

When I first transitioned to full-time freelancing, I folded my health insurance premiums into my business expenses, I also considered the following:

  • Long-term disability insurance. I suffered an eye injury a few months after I started freelancing. In turn, I couldn't work for about a month. That got me thinking seriously about purchasing long-term disability insurance. If I'm unable to work, disability insurance can help me stay on top of my bills. Disability insurance is available from private insurers and also from organizations such as the Freelancers Union.

  • HSAs. As I'm on a high-deductible health plan (HDHP), I squirrel money away into a Health Savings Account (HSA). An HSA can be used for medical-related expenses other than premiums, such as co-pays, procedures, and eligible supplies and equipment. Besides medical expenses, some HSA brokerages have the option of investing any contributions you don't use toward your healthcare.

Explore Retirement Options

When you work for yourself, you'll also need to tend to your retirement savings. While you won't have access to a defined contribution plan from an employer such as 403(b) or 401(k), you'll need to consider the following:

  • IRA. An IRA is a retirement savings option with tax advantages. While this isn't just for self-employed folks, it can be a good option to save for retirement when you're working for yourself. The two main types of IRAs are Roth and Individual IRAs. The main difference is when you're taxed. While contributions to a Roth IRA aren't tax deductible, you won't owe taxes when it's time to take out withdrawals. Contributions to an individual IRA might not be taxed, but you'll need to pay taxes when you start taking money out of your savings plans. For 2022, the maximum contribution for IRAs is $6,000, and $7,000 if you're 50 and older.

  • SEP IRA. A SEP IRA might be a good option if you have employees other than yourself. When I started exploring retirement options as a freelancer, I found the process to open a SEP IRA to be fairly straightforward and easy. While you can save for employees, it can be used if you're the only employee of your company. The contribution limits for 2022 are either 25% of net compensation, or $61,000, whichever is less. So if you're your own employee, and you pay yourself $60,000 a year, you can contribute up to $15,000 into a SEP IRA annually.

  • Solo 401(k). Also known as an individual 401(k), a Solo 401(k) is a retirement savings plan that is only if you're self-employed and don't have any employees. The beauty of a Solo 401(k) is that the contribution limits are higher. You can contribute as both an employer and an employee. For 2022, you can put up to 25% of your compensation on the employer side. On the employee end, you can contribute up to $20,500.

By getting your head around aspects of money management that are specific to being self-employed, such as budgeting and saving on a variable income, and mulling over retirement and health insurance premiums, you can stay on top of your finances and making better decisions.

Jackie Lam

Jackie Lam is a personal finance writer whose work has appeared in Salon, Business Insider, and GOOD.