Money Sense for the Self-Employed

By Rick Shaffer


With the shaky state of the economy in recent years, employment remains a concern for many Americans. People continue to lose their jobs, while many who are employed remain concerned about the prospect of being laid off. As a result, more and more people – either by choice or necessity – are considering earning their living through some form of self-employment.

So, whether you’ve been downsized, fear you soon may be, or have simply decided that you’d prefer to be your own boss, here are some key financial issues to keep in mind.


Emergency Funds

Try to have as large an emergency fund as possible to fall back on. This sum of money should be kept in a safe, liquid account to guarantee that the full amount will be there and easily accessible if and when you need it. Generally, you should have an emergency fund equal to five to seven months of living expenses.

However, for the self-employed, an emergency fund of eight to 10 months of living expenses is preferable.



While doing a careful budget is always important, for the self-employed (especially in the early stages when you don’t know how much you’ll be earning) doing a careful budget and cutting back wherever possible is especially important.

To create an accurate and realistic budget, start by listing your set monthly costs: rent or mortgage, insurance, credit card bills, the per-month average of the vacation you take each year. Next, begin keeping a daily diary of everything you spend money on – gas, groceries, lunch, the newspaper – everything! Do this for three consecutive months, then average out the tab.

Now comes the hard part: where can you cut back? You may find that going out to a fancy restaurant every three weeks, instead of every other week, will save you $100 a month. Perhaps spending one of your two weeks of vacation at home could save you $1,000 per year. Budgeting is not fun or easy, but it is vitally important.


Lowering Loan Payments

You may be able to cut your expenses by lowering your current loan payments. Look into consolidating your outstanding loans to a lower interest rate.

If you have a mortgage, consider refinancing. The accepted rule of thumb for refinancing is … don’t pay attention to the accepted rule of thumb! The rule of thumb regarding refinancing has always been, don’t refinance unless you can drop your interest rate by 2 percent. But this is terrible advice. Instead, consider refinancing if:

• You’ll be in the home for at least four to five years and can recoup the cost of refinancing in less than that time.

• You’ll be in the home for less than four to five years, but can save money by refinancing with a no-point, no-closing-cost loan.

• You currently have an adjustable-rate mortgage and can refinance to a fixed-rate mortgage (to gain certainty and stability in your payments) that is set at the same (or close to the same) rate as your adjustable rate is currently.

If refinancing does make sense for you, try to do so before you become self-employed. Otherwise, it may be difficult to do so for a couple of years. (If you’re self-employed, most conventional secondary mortgage market loans – the loans that usually carry the lowest interest rates – require that you have two years of self-employment income, and two years of tax returns showing such income, before you can qualify for a loan.)

If, however, you’re already self-employed and want to refinance, look into one of the newer so-called NINA loans, which require no income and no asset verification (that is, tax returns or other proof of income) to refinance. Interest rates on these loans are usually somewhat higher than those on full verification loans, but if your current interest rate is relatively high, the rate on a NINA loan may be low enough to make refinancing worthwhile.

When it comes to refinancing, don’t use the equity in your home – via a refinance mortgage, a home equity loan or line of credit – to acquire any cash you need to set up your business. Your primary residence is your home – a necessity – not an investment, and, as such, it should not be put at risk in order to set up your business. Moreover, unless it’s a real emergency or a last resort, don’t use the equity in your home to supplement your income when starting your self-employment. Instead, budget carefully and cut back on your spending wherever possible (see the “Budgeting” section).



If you’re considering becoming (or have already become) self-employed, there are a number of tax- and investment-related issues you should consider.

First, if you have (or had) a 401(k), 403B or other retirement savings plan with your employer, upon leaving the company, immediately arrange to have those funds transferred to an IRA rollover account. There are two reasons to do this:

• While the investment choices offered by your (now former) employer may be good, they are, in almost all cases, limited, and, in all cases, can be changed at any time. However, once transferred to an IRA rollover (which can easily be arranged through one of the large brokerage/investment firms), the investment choices become virtually unlimited and totally in your control.

• More important, although such occurrences are relatively rare, people can lose large portions of their retirement savings when companies (even large, well-established companies) run into major fiscal difficulties.

Next, when beginning your self-employment, consider setting up a self-employment retirement plan. In most cases, a SEP IRA will likely be your best bet.

Remember, you’ll have to begin paying quarterly estimated self-employment taxes (on the profits you expect to make). Along with lowering (or eliminating) any amount you’ll have to pay when filing your tax return, paying quarterly estimated taxes will prevent you from possibly having to pay a penalty for underpayment of taxes.

In addition, if you’re self-employed, you generally have to pay self-employment tax (Schedule SE) – a form of Social Security “withholding” – on your net self-employment income. This includes income earned as an independent contractor, as a sole proprietor of a business or trade and/or as a member of a partnership.

(Wages or salaries you earn as an employee, dividend or interest income and most capital gains income not earned as part of a business, as well as income from most real-estate transactions, are not subject to the self-employment tax.)

Fortunately, you will be able to deduct 50 percent of the self-employment tax you owe. This deduction is especially beneficial since you are allowed the deduction whether or not you itemize other deductions on a Schedule A.

In addition, a number of expenses you’re likely to incur once you are self-employed are fully or partially deductible. These include:

• professional dues and fees

• subscriptions to professional journals

• supplies

• vehicle expenses

• office space rent or home office expenses

• utilities, such as electricity and telephone

• insurance related to your self-employment business

• tax-preparation fees

• a percentage of travel, meal and entertainment costs related to your business

• A portion of the premiums on self-employment health insurance


A Final Word of Advice

Since estimating your net income can be especially difficult when you’re just beginning a self-employment venture – and because the rules governing expense deductions, the self-employment tax and retirement plans are very detailed, can be difficult to understand and have many exceptions – before starting your self-employment venture, it’s best to check with a tax attorney to familiarize yourself with these rules and to set up a plan for tracking and paying the required taxes and to set up a self-employment retirement plan.