Making the Transition from Employee to Consultant
We hear a lot about the Great Resignation these days. A record number of U.S. workers have indeed quit their jobs since the pandemic began—4.4 million left their employers in April 2022 alone. It’s a time of major transition for the American workforce, which just might be a good thing. A recent Pew Research Center survey found that most folks who quit in 2021 were nudged out by low pay, limited advancement opportunities, and feeling disrespected. Those are all solid reasons to go your own way.
You may be considering a transition from regular employee to self-employed consultant. There were 58 million freelancers in the U.S. in 2021, according to Zippia data. That accounted for over a third of the workforce.
It goes without saying that leaving a secure job with a steady paycheck is a huge financial decision. Here are some action items to help set the stage for a smooth transition.
1. Decide if You’re Ready to Leave the W-2 World
A traditional W-2 job has its perks. Depending on your employer, you may have access to benefits like health insurance, paid time off, and a retirement savings program. That’s on top of regular paychecks. We’re not saying these factors should keep you in an unfulfilling role—just that you’ll want to make sure you’re ready to make the leap into consulting. Here are some important questions to ask yourself:
What kind of business do you want to create? Do you see yourself as a one-person show who makes a living as a freelancer? Or do you envision starting a full-fledged business that eventually scales?
What do your startup costs look like? If you plan on working as a remote freelancer, your startup costs may be pretty low. The picture could look different if your business needs office space, equipment, inventory, supplies and so on. You’ll want to make a plan for how you’ll fund your new business. This might include self-funding, seeking investors, or taking out loans or business lines of credit.
Is your emergency fund in good shape? Saving up three to six months’ worth of expenses is a good benchmark for an emergency fund, but you may want to dial that up a little higher if you’re leaving a secure job. It could take time to build your client base, find steady gigs, and become profitable. Having extra padding in your savings account can provide financial peace of mind while you grow your new business.
Will there be customers waiting for you on the other side? The U.S. Small Business Administration suggests doing basic market research to find customers for your new business. Competitive analysis might also give you a leg up over the competition. And don’t forget about marketing, which could translate to another expense.
How much income will you need to support your current lifestyle? This one is tricky because it’s different for everyone. Most of the time you’ll need to make at least 120% of your current W2 salary to cover additional expenses like payroll taxes and benefits. In this country, healthcare is one of the biggest expenses for small businesses. Before you make the leap, understand what your healthcare costs might be.
2. Figure Out Your Health Insurance
If you currently have health insurance through your employer, begin researching the costs of a private policy. The average monthly health insurance premium for one person on a mid-level plan was $450 in 2021, according to eHealth data. That figure doesn’t include subsidies that could reduce your financial burden. Medicaid and the Children’s Health Insurance program are examples of subsidized coverage. You may also be eligible for premium tax credits if you purchase your plan through the Health Insurance Marketplace (operated by the federal government) and meet certain criteria.
Your premium will also depend on the type of plan you choose, along with your state and age. You can compare plans at HealthCare.gov and enroll at any time if you have a qualifying life event—like losing health coverage through your employer. Just keep in mind that health care expenses go beyond just monthly premiums. There are also deductibles, copays, medication costs and other out-of-pocket medical expenses to consider.
3. Understand Your Tax Obligations as a Consultant
Whether you work a regular 9-to-5 job or make a living as a freelancer, consultant or small business owner, you have to pay income taxes on the money you make. With a W-2 job, federal (and possibly state and local) taxes are deducted automatically from your paycheck. It’s a different story for self-employed workers. You’ll be expected to set aside a portion of your earnings and pay estimated quarterly taxes throughout the year. Underpaying could result in an IRS penalty. Brooklyn FI helps dozens of small businesses understand their tax obligation throughout the year. So many of our 9-5 clients make the transition from employee to owner and we’ve got the tools and resources to help.
Your tax liability will depend on things like your gross income, filing status, and whatever tax deductions or credits you may qualify for. This calculator from the Get It Back Campaign can help you ballpark your tax burden.
4. Plan Ahead for Retirement
Going out on your own doesn’t mean you have to stop saving for the future. Freelancers and consultants can explore the following retirement savings options:
Traditional IRA: This is structured similarly to a 401(k). Your contributions may be tax-deductible and your money grows tax-deferred. You’ll be taxed on withdrawals made in retirement, and you’ll have to begin taking required minimum distributions beginning at age 72. In 2022, you can contribute up to $6,000 across all your IRAs; $7,000 if you’re 50 or older.
Roth IRA: Those who meet certain income requirements can contribute to a Roth IRA. This type of retirement account is funded with after-tax dollars, so your contributions are not tax deductible. However, you can withdraw funds whenever you like—completely tax-free.
Solo 401(k): This is a regular 401(k) plan that’s available to business owners who have no employees. They have the same rules and regulations as a traditional 401(k). It’s unique in that the business owner can make contributions as both the employer and employee. A solo 401(k) can help beef up your contributions and business deductions. In 2022, you can contribute up to $20,500 in elective deferrals. As the employer, you can put in up to 25% of compensation up to $61,000.
Making the jump from regular employee to consultant is a big life change. Organizations like the Freelancers Union can be a great resource for information and support. You can also look to freelancing groups within your specific industry. Many have online communities where folks can brainstorm, share challenges and pain points, and find guidance and support.
The self-employed life can pave the way for greater work satisfaction and a more flexible schedule, but getting there might take some time—especially if you’re bootstrapping your way through the early months. In the end, every business (and person) is different. We’re here to help you prep your finances if you need the insights of a pro.