A husband wants to know the impact of choosing self-employment
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 the impact 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 about losing his current employer's 11% annual retirement benefit contribution. He's unsure whether he could replace the benefit contribution over the long term while self-employed.
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.
The What-If Plan: Self-Employed
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 now must 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 increasing 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
Naturally, there is a great deal of speculation within this model. We have to speculate Hector's earnings over a long period of time. However, by comparing the Base Plan to the self-employment What-If plan, Hector and Maria see that considering self-employment is a reasonable and plausible option. 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 slightly 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 while financial planning for self employment. 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.