This month my husband and I are celebrating one year of his self-employment. Last April he stepped away from the security of regular paychecks and employee benefits to start his own construction company. As his supportive wife and his financial advisor (package deal if you ask me), I’ve had my pen to paper for the better half of a decade financially preparing to bring his dreams to fruition. If he was going to take the plunge into self-employment, I had to make sure we did it right – which meant planning for every known variable within our control. One such variable which I didn’t expect to consider while planning for the launch of a business in our twenties is Social Security. Specifically, how the taxes we pay in and the benefits we will claim later would impact the business and our eventual retirement. If self-employment is relevant to you, here are some social security considerations you need to write into your financial plan:
Social Security Taxes: When you work for an employer, you and your employer equally share the burden of the Social Security tax. The employer deducts 7.65% of your earnings from your paycheck, matches your 7.65%, and reports your wages to the IRS. When you are self-employed, you pay the combined employee and employer amount of 15.3%, also referred to as the Self Employment (SE) tax. You will report your earnings directly to the IRS when you file your federal income tax return. Net earnings for social security are your gross earnings from your business, less your allowable business deductions. For many new businesses, slim profit margins are expected in the early years, so the extra 7.65% tax is important to account for. Fortunately, the self-employed get two income tax deductions to lessen the blow of the SE tax: (1) net earnings from self-employment are reduced by half the amount of your Social Security tax, and (2) half of the Social Security tax can be deducted from gross income on your Form 1040, reducing your adjusted gross income.
Social Security Benefits: The Social Security taxes you pay in over the years determine your eligibility for benefits later. Your benefits are based on your 35 best-paid years. So, if you were self-employed for the greater part of your career and successfully maximized allowable deductions over those years to reduce your SE tax, then it’s reasonable to expect less in Social Security benefits. Your benefits will likely make up a smaller portion of your retirement funding than your W-2 employed counterparts. Fortunately however, self-employment opens the door to robust retirement planning strategies, such as higher annual contribution limits and tax deductions that come along with those contributions.
Financial planning in the formative years of self-employment can set the cornerstone of a successful business and eventual retirement, but don’t 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, rather than waiting until you file your taxes and being surprised with missed opportunities.
Published in the Victoria Advocate
Hannah Gohmert is a CFP® professional and Chief Compliance Officer with KMH Wealth Management, LLC.