Millions of Americans are seeking better, more fulfilling work. A report from the Bureau of Labor Statistics found that 47.8 million workers left their job voluntarily in 2021, and many of that number were women. Where are they going? Since 2007, the number of businesses owned by women has grown by 58%.1
Starting your own business can be the most rewarding thing you’ll ever do in your career, both financially and personally. However, before you leap, there are some financial considerations to think through.
One of the biggest hurdles aspiring entrepreneurs face is replacing employer benefits. If you are taking advantage of employer-provided insurance, you’ll most likely need to get coverage unless you can access a spouse’s plan. The Affordable Care Act health care exchanges can provide you with coverage, and you may be able to access a subsidy to make it more affordable. If the deductible on your policy is high enough, you may also qualify for a Health Savings Account (HSA), which can lower your taxable income and allow for tax-free growth of the savings.
Aside from health insurance, another necessary form of coverage is disability. As a business owner, you need to protect your greatest asset – your ability to earn an income. Disability insurance is designed to issue payments regularly if you cannot work due to an injury. It is available as both short-term and long-term coverage.
Depending on your life stage and personal situation, you may also need adequate life insurance coverage. Generally, anyone with dependents needs to have some form of life insurance, and between the two standard options – term and whole life – term is much more affordable and provides sufficient benefits for a majority of people.
If you have a 401(k) at your current employer, you have a few options for how to manage it after leaving. First, if you have over $5,000 invested within it, they generally allow you to leave it where it is. If you aren’t eligible to leave it in place, or want to move it, you’ll need to set up an IRA to complete a rollover. This will give you more investment options and flexibility, but it’s important to note that after withdrawing funds from your 401(k), you only have 60 days to deposit it into a new account, or you will owe penalties and taxes.
The least prudent yet commonly taken route for entrepreneurs is to use some of the funds to invest in the business and help cover start-up costs. If possible, it’s best to avoid this option because if you choose to cash out a 401(k) before retirement, you’d owe a 10% penalty and income taxes would be due on the withdrawn funds. You’ll also be short-changing your retirement and increasing your risk profile by concentrating your net worth on your new business.
As a newly self-employed individual, there are a few different options for available retirement accounts:
Solo 401(k) – Your business must not have any employees to open a Solo 401(k). The annual contribution limit in 2022 is $61,000 (plus an additional $6,500 if over age 50) or 100% of earned income, whichever is less.
SEP IRA – Businesses with or without employees can open a SEP IRA. The annual contribution limit in 2022 is $61,000 or 25% of compensation of net self-employment earnings (up to $290,000), whichever is less.
Traditional (or Roth) IRA – Depending on your income levels, you can also contribute to an IRA, which has lower contribution limits than the other options ($6,000, or $7,000 if over age 50).
After making the transition to self-employment, you’ll quickly realize that you have many more responsibilities. One of the biggest? Taxes. As an entrepreneur, you’re responsible for reporting your income and withholding taxes from payments you receive.
You must pay estimated quarterly taxes if you expect to owe more than $1,000 in a given tax year. These must be paid each quarter and it’s generally recommended to set aside 25-30% of your self-employed income to cover the potential tax bill. This is higher than normal because you’re subject to an additional self-employment tax. When you earn W-2 income, your employer covers half of the tax. You’re the employer and the employee, so you pay the entire amount.
Taxes are typically one of the largest expenses for a small business, so it’s crucial to plan ahead to avoid getting into a financial bind.
There are a lot of financial and lifestyle adjustments to take into account when transitioning to self-employment, but one of the most surprising is the difficulties with qualifying for a mortgage. Because banks and lenders view income from a traditional job (W-2) as more stable than an entrepreneur’s income, it’s much more challenging to qualify for a significant loan. Also, because many business owners take advantage of tax deductions to reduce their taxable income, they get caught in a scenario where they may have to wait a few additional years and report more income to qualify.
On top of everything mentioned so far, you also need to consider your start-up costs. Have you thought through all the expenses required to make your idea a reality? Some commonly missed expenses are state, local, and city business fees, necessary software to operate your business, marketing costs, and customer acquisition costs. By thinking through what needs to happen to get up and running, you can be better prepared financially.
As more and more workers aim to pursue their passions, there are a lot of financial considerations to keep in mind. You need to have a plan for insurance coverage, retirement contributions, and taxes, as these situations change once you enter self-employment. A financial advisor can help you work through the numbers and routes to help you confidently transition into entrepreneurship, knowing that everything has been thought through and accounted for financially.
- Women’s Business Enterprise Council