With unemployment stubbornly sticking north of 8 percent, Self-Employment Costthe prospect of self-employment becomes more and more tempting. A significant number of the unemployed or under-employed are forced into unemployment out of economic necessity. Some of you will jump at the first chance to go back on staff as a W-2 employee somewhere. Others will relish self-employment and embrace the challenges. In either case, though, you have got to be aware of the substantial hidden costs, traps and challenges of self-employment.

FICA Taxes

Lots of self-employed individuals forget about this one: Until they file their taxes. But if you make more than $400 this year from self-employment, you may be in for a nasty tax surprise:

Normally, employers will zap an employee’s paycheck for 4.2 percent of their income for FICA taxes – the combined set of taxes that goes to fund Social Security (OASDI) and Medicare (hospital insurance). So most working stiffs barely notice what comes out of their paychecks. But it gets even worse: Workers only pay a portion of their payroll taxes. The employer picks up the lion’s share of the tax liability, and forwards payroll taxes to the IRS every year in a process that’s invisible to the employee.

If you’re self-employed in any capacity, expect to pay a total of 13.2 percent in self-employment taxes this year, and 15.2 percent in self-employment taxes next year. That means you get to keep less than 85 percent on every dollar you make in net income from self-employment. Just put that money aside as you earn it and forget about it until you file taxes.

A lot of self-employed artists, consultants, massage therapists, music teachers, yoga instructors, fitness coaches, computer technicians, and everyone else you can imagine forgets about this tax – and undercharges substantially.

Business Acquisition Costs

This is huge – and it’s something most W-2 workers don’t see. But it takes time, effort or money or all three to land a new client. Every piece of new business, or every new client, needs to be identified, courted, presented and closed-on. This could take hours, weeks, or months. You might have to invest time writing cover letters or proposals and negotiating. You may have to advertise – and spend time developing your advertising materials and strategy. You may have to network. You may have to buy business lunches. New customers can cost hundreds of dollars’ worth of your cash or your time. These hours aren’t directly billable to any one client – and the expenses aren’t something you can pass on directly. You have to account for them and work them into your fees. Many new self-employed individuals grossly underestimate the cost of business acquisition.

Medical Insurance

This one’s usually obvious. But when you were employed by someone else, chances are they paid half of your medical insurance premiums for you. Now that you’re self-employed, it’s all on you. If you and everyone in your family are in good health, you can still do OK by buying a high-deductible policy for yourself and your family. If one of your family members has some health issues, you will have to pay more – if you can get insured at all. Health care reforms won’t force insurers to stop discriminating against those with pre-existing conditions until 2014. In the meantime, you are on your own. You may be able to extend coverage via COBRA. This may work for you if you do have some health issues.

Unemployment Insurance

When you were employed, your employer paid unemployment insurance premiums on your behalf. Then when you lost your job, most of you could qualify for benefits to keep a roof over your head – at least for a period of time. There’s no unemployment insurance for the self-employed, though. You can’t be laid off, and if your income falls, authorities figure it’s your fault. Go get some clients!

Well, I’m self-employed, so that’s what I do, as a freelance writer. But that solution isn’t so easy for some people, depending on your industry, skill set and temperament.

To mitigate this issue, you may consider starting a corporation, and becoming an employee of that corporation. However, for you to qualify for unemployment benefits, your corporation must pay unemployment insurance premiums on your behalf.

Accounting / Bookkeeping Fees

Starting a business? Accounting is half the battle. If you don’t have a method for tracking income and expenses, you don’t have a viable business. But this takes time, money or both. At a minimum, you will need to set up a spreadsheet and spend time maintaining it. Or you may need to invest in accounting software. Or hire a bookkeeper or accountant. You didn’t need to worry about this as an employee. But when you become self-employed, it’s extremely important.

Disability Insurance

What happens to your income if you become sick or hurt? For most regular employees at established companies, disability insurance kicks in. Disability insurance provides a cash income cushion while you recover from an illness or injury, or retrain for a new job. Your employer was probably paying the premiums on your behalf as an employee benefit. But good disability coverage is expensive, and difficult to qualify for. It’s based on your medical history and your income, but you have to be able to verify your income to get an individual plan. This is very tough to do for the newly self-employed, because you usually have to come up with several years’ tax returns.

Which means your real disability insurance coverage is going to come from your savings, at least for a while.

Vacation

Remember those blissful vacations from your job where you could take off a week or even two weeks and not have a care in the world? And you’d still get paid? Those days are over. When you’re self-employed, you eat what you kill, no exceptions. There are no vacation days, no paid-time-off (PTO) days, and no paid holidays. Three-day weekends now have a price in lost productivity. Weekends are no longer really “off.” And you may need to set up a reserve fund to keep you going through the whole holiday season when business is often slow.

Overtime

Were you used to earning overtime? Fugeddaboutit! Overtime is for W-2 employees, not for the self-employed. That’s for working stiffs. Not for you! You might be able to raise your rates to account for an extra work load. Or you can subcontract part of it out. If you hire someone, though, you will have to pay overtime for hours worked over 40 in a week!
All these are real costs of self-employment, and you’ll need to pay them, one way or another, either in cash, or in the form of increased risk. Be sure to account for these explicit and implicit costs when pricing your services as a self-employed individual.