There are many aspects of self-employment that are attractive — but there are many financial responsibilities that accompany setting up your own business. If you are track your income and expenses and make sure your taxes are paid and filed correctly, self-employment can be a great career choice. If not, it can lead to major financial setbacks.

Note: This article is for self-employed individuals who do not have staff. If you’re looking for information on how to run a small business, visit:

• U.S. Small Business Administration (SBA): www.sba.gov

What is self-employment?

In general, self-employment is working for yourself, rather than as an employee. Self-employment is the term you see a lot when preparing income taxes, but you might also see it described as freelancing, contract work or working as an independent contractor. Most people who are self-employed do business as a sole proprietorship which is just what a single-person business is when you don’t form an entity like a corporation or limited liability company.

How to start with self-employment

As with anything, in order to succeed in self employment you have to have a long-term plan. Here are seven components of your self-employment plan:

Budgeting

Self-employed workers need strong budgeting skills in order to survive. Budgeting simply means looking at your income and your expenses, and making sure you have enough money coming in to cover the costs of your operation and expenses.

As a self-employed person, you’re on the hook for covering your own health care expenses, your own retirement savings, taxes, professional development, supplies — all those expenses that an employer usually covers. If you don’t plan ahead for all these expenses, you risk getting into financial trouble.

When you budget for self-employment, you need to:

• Look at how much it costs to run your business on a monthly basis
• Understand how that amount changes in the course of a year
• Track your expenses and keep track of all your receipts
• Open separate bank and credit card accounts for your business, so you keep work and personal expenses separate
• Calculate your actual income and how much you’ll need to pay in taxes including self-employment taxes
• Decide on a budget goal for how much money you need to earn to cover all your costs (this will help you set your minimum rate)

A budget doesn’t have to be complicated, but it’s necessary for planning ahead and reducing the risk that comes from unexpected surprises. It’s a tool for providing you, as a self-employed worker, the information you need to be successful.

If you’re working full-time and planning to leave your job, take stock of all your employer benefits and do some research to see how much those expenses might add up to if you have to pay them out-of-pocket. This will give you an idea of if you can afford to go off on your own.

Saving

Before you start with self-employment, you need to look at how much money you have in savings and whether it is enough. Self-employment means you’re on the hook for both finding and doing the work — and whether you get work depends on:

• Your skill and whether there’s a market for it
• Your network and potential clients (called a “pipeline”)
• How good you are at winning work
• Whether there is work available

If you’re just starting out, consider working part-time on the side of full-time employment until you have enough work coming in to make a regular income. As you earn this money, put it in savings — avoid the temptation to spend it. Over time, you’ll build enough of a network and enough in savings to actually make the shift to being fully self-employed.

Once you’re self-employed full-time, you need to plan ahead for downtime where you find business is slow or ramping up. When that happens, you want to have financial reserves so you have enough money to cover your living expenses and, if you have operational costs like rent, to cover those costs. One big mistake self-employed people make is saving too little and finding themselves in a pinch when work isn’t available.

Forecasting

Forecasting is estimating how your business will do in the near future — the next year or two, for example. It’s both an art and a science. It’s a way to help you realistically determine a budget and set aside enough savings.

When you forecast, look at:

• How long it will take to start earning money in your business
• How many months of the year will you be employed
• Will that employment be full- or part-time
• Predict downtime based on your field

In the beginning, be very careful with forecasting. In general, it’s better to under-estimate the amount of income you’ll have and save more — especially when you’re just starting out. Each year you work, you’ll learn more about how to accurately forecast — soon, you’ll be more precise at setting realistic goals and setting budgets that will cover income, expenses and saving.

Accounting

Accounting simply means keeping track of your sales, expenses, and taxes. Unless you have some type of accounting process in place, you’ll never know whether you’re making or losing money in your business.

As part of your accounting practice, make sure you:

• Carefully track money coming in (revenue)
• Carefully track money going out (expenses) and keep receipts
• Review your forecast and budget every few months to adjust to your income and expenses

There are many tools for small business accounting, including:

• QuickBooks: quickbooks.intuit.com
• FreshBooks: www.freshbooks.com
• PeachTree: www.peachtree.com
• Outright: outright.com

Unless you’re familiar with accounting, it’s usually a good idea to work with an accountant or bookkeeper to at least help you get your basic accounting set up. If you delay it until it’s time to file your income taxes, you’ll be in a world of hurt.

• See also: Income tax returns, Financial professionals, Budgeting, Saving

What do I have to know about self-employment and taxes?

Self-employed individuals have some tax advantages and requirements that are different from full-time employees. There are three things you need to know:

• How to pay taxes
• What constitutes allowable business expenses
• The tax benefits that come from funding a retirement account

How to pay taxes when you’re self-employed

Most self-employed individuals do not pay taxes on income earned throughout the year through withholding, because they don’t receive paychecks. The IRS doesn’t want to wait for you to pay taxes, however. So self-employed individuals are required to pay quarterly estimated taxes. If you don’t pay quarterly estimated taxes, you may have to pay a penalty when you file taxes and pay the balance due the following April.

In addition to income taxes, self-employed individuals also must pay the self-employment tax, which covers taxes for Social Security and Medicare. If you live in a state that requires income tax, you may be responsible for paying that quarterly as well.

• See also: Withholding and estimated taxes, Income tax returns

One of the biggest mistakes self-employed individuals make is falling behind on taxes or not saving enough money to cover tax payments. Typically when you’re self-employed, you have to pay your tax out-of-pocket. Make sure to stay on top of taxes so you don’t end up in a financial mess.

If you are self-employed, we recommend that you work throughout the year with a tax professional, who can make sure you’re paying the right amount, can send you a notice when it’s time to pay your taxes and can help you make sure your filing your income tax returns correctly.

• See also: Tax professionals, Withholding and estimated taxes

Federal and state income tax

Your self-employment income is fully taxable — but the amount of taxable income you have comes after you’ve deducted all of your allowable business expenses. You figure this out on Schedule C of your federal income tax return.

• IRS Schedule C: www.irs.gov/pub/irs-pdf/f1040sc.pdf

Run through the form to get a basic understanding of how you’ll figure this out. If your state has an income tax, income is usually calculated the same way, but there can be differences if you buy a lot of equipment for your business and take depreciation deductions.

Once you know your self-employment income, you still need to figure out what income tax will be due on it. The worksheet for Form 1040-ES, where you figure out estimated taxes, can be helpful, but if you have other income or a lot of itemized deductions, you may want to use tax software or meet with a tax professional.

Self-employment tax

Self-Employment (SE) tax is a social security and Medicare tax for individuals who work for themselves. Your payments of SE tax contribute to your coverage under the social security system. Social security coverage provides you with retirement benefits, disability benefits, survivor benefits and hospital insurance (Medicare) benefits.

• IRS Self-employment Tax: www.irs.gov/businesses/small/article/0,,id=98846,00.html

As a self-employed individual you are responsible for paying the full self-employment tax. For full-time employees, their employers pay half of the Social Security and Medicare taxes on their behalf.

• See also: Income tax returns, Social Security and Medicare

In order to pay SE tax, you have to file a Schedule SE (Form 1040) if your income from self-employment is $400 or more. You can deduct one-half of your SE tax as an adjustment to income on your Form 1040.

• IRS Form 1040 SSE: www.irs.gov/instructions/i1040sse/index.html

To pay self-employment tax, you must have a Social Security number (SSN) or an individual taxpayer identification number (ITIN).

• See also: Withholding and estimated taxes