W-2 to Schedule C: What to Consider
We often explore the idea of transitioning from a W-2 employee to a Schedule C with clients during their working years. Many want to use their deep expertise and years of experience to consult with organizations or provide services like a therapist or a ...ahem...financial advisor 😉.
A key consideration during the planning is this: How much income do I need to earn? Those of us who’ve taken this leap know it takes time to get things up and running. Ideally, you will have a reserve to supplement your income during the start-up phase. But what about once you get going? How low can you go?
If you believe your business will earn around the same as your gross W-2 wages, you should add around 20-25% to that number to ‘break even’. This estimate is to account for the loss of employer benefits and the double taxation as both an employer and employee. And while you do get extra business expense deductions, it often doesn’t cover everything.
If the success of your financial plan requires earning more than what your business will cover, we will dig into your plan to find trade-offs to consider; reducing living expenses, postponing goals, retiring later, etc. We work together to think through all the possibilities so we can help you realize your goals while following your passions.
Since it can be foreign to most lifelong W-2 folks, below are some key financial advantages and disadvantages of being self-employed and filing an IRS Schedule C on your 1040 tax return.
Schedule C Advantages
· W-2 employees can’t deduct anything. In theory, the employer is paying for everything, but that’s obviously not true for some things like commuting, home office, and small items. 1099s can get deductions on all expenses for home office, telephone, information services, and transportation, but not personal care. Credit card statements are fine, and you usually don't need to save receipts unless the item is big and unusual.
o The business tax deduction is best thought of as a government-subsidized "discount" on your small business costs. For most of us, it's approximately 30% between state and federal taxes.
o Bonus: If the item overlaps with home and lifestyle expenses you would have spent/bought already, this tax deduction benefits you doubly. The more your business and lifestyle overlap, the better.
· Schedule Cs have access to a SEP IRA and Solo 401(k), which are more flexible. The Solo 401(k) is particularly robust. It offers all the best features of an IRA and 401(k) and is more customizable than most employer 401(k)s. And you can contribute both as the employer and employee, so there are higher contribution limits than employee 401(k)s or SEP IRAs. This is excellent for households in high tax brackets. We are one of the few advisors who create these for clients, as they are not as accessible to consumers as a SEP IRA.
· S-Corps are a possibility for Schedule C small businesses. The benefits phase in between a net income of $100K and $200K, are from $2500 to $5000 tax savings if the owner is paying themselves $200K. There is a small loss in social security, which might make it disadvantageous if you live to 100.
Schedule C Disadvantages
· Schedule Cs have a ~10% tax loss compared to W-2 between the typical 401(k) match (3%) and FICA and Medicare (7%).
· There is, of course, no overtime, vacation or sick leave either—adding up to an additional loss of around 5-10% depending on the circumstance.
· Schedule Cs generally must file estimated tax payments quarterly.
· Loss of key insurances (short-term disability and long-term disability) and unemployment plans are generally harder to get individually. Health care is less so than it used to be (thanks, Obama!), and if your spouse’s job can cover that, it's not an issue for your household.
As with everything, switching to self-employment has its challenges, but the reward of working for yourself and pursuing your goals is usually worth it. If you want to explore how this could fit into your financial plan, schedule a chat with us.