This month, my husband and I are celebrating a year of his self-employment. In April last year, he stepped away from the security of ordinary payslips and employee benefits to start his own construction company.
As his supportive wife and his financial advisor (package deal, if you ask me), I have had my pen on paper for more than half a decade of financial preparation to make his dreams come true. If he was to take the plunge into self-employment, I had to make sure we did it right – which meant planning for any known variable within our control.
One such variable that I did not expect to consider while planning the launch of a business in the twenties is social security.
Specifically, how the taxes we pay and the benefits we will claim later would affect the business and our eventual retirement. If self-employment is relevant to you, here are some social security considerations you should include in your financial plan:
Social security taxes: When you work for an employer, you and your employer share the burden of the social security tax equally. The employer deducts 7.65% of your earnings from your paycheck, matches your 7.65%, and reports your salary to the IRS.
When you are self-employed, you pay the combined employee and employer amount of 15.3%, also called Self Employment (SE) tax. You will report your earnings directly to the IRS when you file your federal tax return. Net earnings for social security are your gross earnings from your business, minus your allowable business deductions.
For many new businesses, small profit margins are expected in the early years, so the extra tax of 7.65% is important to take into account. Fortunately, the self-employed receive two income tax deductions to reduce the impact of the SE tax: (1) net income from self-employment is reduced by half of your social security tax and (2) half of the social security tax can be deducted from the gross income on your Form 1040, which reduces your adjusted gross income.
Social benefits: The social security taxes you pay over the years determine your entitlement to benefits later. Your benefits are based on your 35 highest paid years. So if you were self-employed for most of your career and successfully maximized allowable deductions in those years to reduce your SE tax, then it is reasonable to expect less in social benefits. Your benefits are likely to make up a smaller portion of your pension financing than your W-2 employee counterparties.
Fortunately, however, self-employment opens the door to robust pension planning strategies, such as higher annual contribution limits and tax deductions that come with these contributions.
Financial planning in the formative years of self-employment can set the cornerstone of a successful business and eventual retirement, but do not go it alone. Plan for the variables that are within your control by having your CFP professional and CPA work closely together throughout the year to take advantage of strategies as they arise, instead of waiting until you file your taxes and be amazed at missed opportunities.
Hannah Gohmert is a CFP Professional and Chief Compliance Officer at KMH Wealth Management, LLC.