May 24, 2017

How to Compare Consulting or Freelance Rates to a Salary

This entry is part 1 of 4 in the series Independent Consulting and Freelance Secrets and Tips

After many years or even decades as an employee, most people fantasize about being their own boss, working from home, setting their own hours, and being able to deduct many of the expenses they cannot easily deduct as employees. If you have a specific business opportunity in mind, and know approximately what your revenue and business expenses are likely to be, following the steps below you’ll be able to figure out how your net business income will stack up compared to your salary.

Step 1: The Hidden Costs of Being an Employee

First, figure out current expenses that go away once you go into business for yourself. If your business does not require business attire, you’ll save the cost of pants, shirts, ties, and suits you no longer need to buy, as well dry-cleaning costs. If you plan to work from home, you can scratch out the cost of commuting, including gas, routine maintenance, tolls, parking, and occasional repairs, as well as the decreased depreciation from miles you no longer pile on your personal vehicle. Tally these up and subtract from your take-home salary (i.e. after deductions such as federal, state and local income taxes, Social Security and Medicare/Medicaid taxes, health insurance premiums, and disability plans). This is your true net salary.

Step 2: The Hidden Costs of Being Self-Employed

As an independent consultant or freelancer you can deduct the costs of all legitimate business-related expenses. These vary by the type of business, and are thus beyond the scope of this article. On the other hand, don’t forget to account for any employer contribution to your pension plan, 401(k), 403(b), etc. which you should replace with your own plan (e.g. an SEP-IRA), reducing your tax liability, but also your spendable take-home income.

As an independent consultant or freelancer, unless you’re covered by someone else’s plan (e.g. spouse or parent) you’ll need to buy your own health insurance and any short term and long term disability coverage. Note that disability coverage requires enough of a track record of self-employed income to satisfy the insurer, so you may not be eligible yet. Your health coverage may be COBRA coverage from your former employer (up to 18 months). This is likely to be at least 5-10 times more expensive than what an employee pays (the employer usually contributes 80%-90% of the cost of coverage but will not do so under COBRA). If you have no COBRA option, or even if you do, you may opt to buy private health insurance which is likely to be much less expensive but less generous in its terms of coverage. This does assume you can find a plan you like and can qualify for. Subtract this cost too from your expected business profit.

Assuming you know what your business top-line income and expenses are likely to be, you can use any of several popular tax preparation software packages (e.g. TurboTax, etc.) to calculate your income tax (federal, state and local) and self employment tax, accounting for any personal exemptions, tax credits, etc. Note that as an independent consultant or freelancer, your self-employment tax will include the employer portion of Social Security and Medicare/Medicaid taxes. This normally doubles the rate you pay. In 2011 the employee part of Social Security tax is being cut from 7.65% to 5.65%, but the employer contribution is not. As long as that remains the case, self employment taxes will be more than double the employee contribution. Subtract these taxes as well from your business profit to obtain your spendable take-home income.

Step 3: “Apples to Apples” Comparison of a Salary vs. Self-Employment Income

In step 2 above, you should have deducted all legitimate business expenses, which is usually much more comprehensive than what an employee can deduct. If you’ve identified more expenses than those mentioned in step 1, you should revisit that step and subtract those expenses from your take home wages as an employee to make sure you’re comparing apples to apples.

The Bottom Line of Comparing Self Employment to being an Employee

There are many advantages to being self-employed, and normally your hourly compensation will be much higher than what you were paid as an employee – after all, if you weren’t bringing in a profit for your employer, you would likely have been paid less, or been laid off. However, after accounting for all the hidden costs both as an employee and as an independent consultant of freelancer, and taking into account the risks of being self employed, you might find that the financial case at least is less clear-cut. Often the decision will hinge on how many hours you can expect to bill as a consultant or freelancer, and at what hourly consulting rate you set, and/or how you quote fixed price jobs.

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Series NavigationThe Risks of being an Independent Consultant or Freelancer

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