A couple explores the option of the husband quitting his job with excellent retirement benefits and becoming self-employed.
Married couple, Age: 45
Hector’s earnings: $90,000
Maria's earnings: $60,000
401K savings: $225,000
Hector's Employer Contributions: $9,900
Hector's Individual Contributions: $4,000
Hector and Maria want to know what kind of impact it would have on their finances—current and future—if Hector were to leave his job as a computer programmer and become self-employed. He is confident he can improve his $90,000 annual salary but he's not sure if losing his current employer's 11% annual retirement benefit contribution is something that he could replace over the long term.
He could contribute more to an IRA out of his own self-employment earnings, but paying one's own self-employment tax is also costly. This would all change the Social Security benefit at age 66 as well. It seems impossible to figure out.
The Base Plan
Hector stays in his current job
Hector and Maria create a Base Plan and learn that if they continue on their current path, they will have $79,746 in annual discretionary spending each year through age 100.
Discretionary spending is the amount left over to spend each year after paying fixed expenses: taxes, housing costs, and Medicare Plan B costs (in their retirement years). This amount is in "today's dollars," which means it's adjusted for inflation each year and it remains steady even though fixed spending changes. Of course the Social Security benefit is not their only income in retirement. They also have withdrawals from their 401K which will have grown to $690,268 (in today's dollars) by the time Hector is 65.
Self-Employed at age 46
If they run the program again but this time indicate in their model that Dave becomes self-employed next year they learn that they can have $83,695 in discretionary spending. That's $3,949 more to spend each year, adjusted for inflation, for the rest of their lives—5% more to spend each year than they currently have.
The What-If Plan
Hector switches to self-employment at age 46
If they run the program again but this time indicate that Hector becomes self-employed next year, they learn they can have $83,695 in annual discretionary spending. That's $3,949 more to spend each year, adjusted for inflation, for the rest of their lives—5% more to spend each year than they currently have.
Is the plan realistic?
Becoming self-employed will allow Hector to increase his annual income from $90K to $120K per year. However, he must now pay self-employment tax (his own FICA), and this is no small sum. Furthermore, he loses the employer contribution of 11% or $9,900 each year, which he must address by bolstering his individual contributions from $4K to $12K annually through to retirement. When Hector compares his two Plans, he notices that his household tax liability has gone up about $10K per year over the next twenty years. He also notices that he only accumulates $642,944 in retirement assets if he sticks to his new plan (a little less than the $690,268 he was on a path to save in his current job).
The Bottom Line
There is, of course, quite a bit of speculation built into this model about the next twenty years of employment, not to mention the retirement years. But given the Base Plan compared to the What-If plan that includes self-employment, Hector and Maria learn that considering self-employment is certainly reasonable. What Hector loses in employer benefits he makes up for in salary, even after he considers that he must pay higher employment taxes and contribute more to his own retirement plan. He will also have a little better Social Security benefit when he retires using the "self-employed" plan.
Every household economy is unique, and MaxiFi software will help you to explore many options. But most importantly, you are not comparing "theories" or "rules of thumb," you are using accurate numbers to compare the real, annual impact on your living standard.