By Kathie Larsen, PhD
The focus of this article is on helping you figure out how much money you need to make in your business in order to meet your goals.
What is your goal in starting this business?
- To be able to work for yourself, replacing your current job
- To enable you to work more flexibly so that you can take care of a child or a parent, or pursue avocational interests
- To provide something productive to do and a stream of income in your retirement
- To get rich quick
If you marked the last one, you are at the wrong website. Your own business may make you happy, it may support you and your family, but if you ever get rich from your own business, it will be slowly.
How much would I have to earn to replace my current salary?
When you consider how much you would need to make to replace your current salary, there are a number of things to consider.
First, remember that the money coming in isn’t all profit. It took money to bring in those first dollars – probably lots more than what you initially brought in. You had start-up costs, and you have continuing costs in running a business. The money that comes in is your gross. Once you subtract your business expenses, you have your net, or your profit. But even your profit isn’t money you can spend.
Once you have profits (the gross income from your business minus your expenses), you’ll need to start paying quarterly estimated taxes. These estimated taxes are the income taxes that were previously withheld from your paycheck and FICA, your social security and Medicare taxes. When you are an employee, your employer pays half of your FICA and Medicare tax and you pay the other half. But once you are self-employed, you have to pay all of it.
From your first dollar of profit, you owe FICA and Medicare (15%). You also will owe income taxes. While income tax rates are tiered, remember that your marginal tax rate is determined by the household income. So if you have income from other sources or if your spouse has income from other sources, you should probably estimate your marginal tax rate as 25%. Thus, 40% of your profits go to federal taxes. You will also have to consider state and local taxes.
Most people who are salaried workers have some kind of retirement sponsored by their employer. Often it is a 401k that you put money into which is invested for you retirement. Some employers also offer some match of what the employee contributes. For instance, you employer may allow you to contribute up to 10% of your income to the plan, and the employer may match one dollar for every two or four or five dollars you contribute. This money is tax-sheltered and is not taxed until you withdraw it. You do pay FICA and Medicare on the money you contribute, but not on your employer’s contributions.
As someone who is self employed, you can create your own retirement plan. There are two options. One is the SEP IRA, which allows you to contribute up to 20% of your net on a pre-tax basis, up to a maximum of $49,000 in 2009. The other is a SIMPLE IRA, which has a maximum contribution amount of $11,500 in 2009 ($14,000 for people over 50). The SIMPLE IRA contribution is not limited to a percentage of your net income.
An Example: For every $100 of net income to your business, you’ll pay $15 in FICA and Medicare and $25 in Federal income tax. This leaves $60.
But if you contribute to a SEP, you can contribute 20% of your net, $20 out of that $100. That changes your taxes, as this money is tax-sheltered. You do pay FICA and Medicare on the money, but not income tax. So your quarterly taxes would take 15% of $100 ($15) and 25% of $80 ($20). So out of the $100, you’ll find you have $45 that is yours after taxes and your retirement contribution. When you contribute $20 to your retirement plan, and it costs you $15 because of the tax advantage of contributing to a retirement account.
Remember also that being self-employed means no paid vacation, no sick leave. You need to have reserves, money you save out of your profits to allow for this.
Health insurance is also a consideration. Your employer likely pays a significant amount go your health insurance premium. Now you will be paying your whole health insurance premium.
You do get some tax breaks. You get a tax deduction for half of the amount you pay for FICA and Medicare. You also get a tax deduction on half of the health insurance premium you pay.
Do I need to replace my salary?
If, at this point, you are looking at the numbers and thinking there is no way I can replace my salary, consider whether you need to replace your salary.
Many people start their own business as a transition to retirement from their old job. In this case, you are not aiming to replace your salary but to augment your retirement income to bring closer to your old salary.
Also consider whether you can live on less money. Working for yourself is often a lifestyle decision. Being self-employed can give you more flexibility about when and how and where you work. You may be willing to make less money to have the advantage of, say, no long commute or being able to see your children off to school in the morning or to take your mother to the doctor in the middle of the day.
If you believe you can live on less money, try it – not just for a month but for a full year. Not only will this tell you whether you can realistically live happily on less money, but if you save the difference between living on less and spending what you previously did, you’ll have some money saved for starting your business.
Remember that no one starts out replacing his or her salary. The rule of thumb is that it takes 2 years to make money in your own business. “Making money” means different things to different people, but most people take this to mean nearly replacing their salary.
Starting your own business is a good example of the old adage that “it takes money to make money.”
