Earning

What you need to know about money before quitting a job to work for yourself

Welcome to Asking for a Friend, Grow's money advice column. Got a question for one of our money experts? Email us at getgrowing@cnbc.com.

Dear Asking for a Friend,

I've started thinking that I would like to work for myself. What kind of money action plan do you need to put in place if you decide you want or need to work freelance?

Sincerely,

Hopeful Freelancer

*

Dear Hopeful Freelancer,

Four years ago, while walking laps around Madison Square Park during my lunch break, I realized it was time to take the leap into freelance life.

Nothing upsetting had happened that day. I actually quite enjoyed my job. But something in me wanted to see if I had what it took to become my own boss and ultimately build a brand and a company.

I also knew my generally low risk tolerance would prevent me from leaving the security of a stable income and benefits if I got much further in my career. I made that decision about six months before I put in my notice, because financially planning to become a freelancer can be a determining factor in whether you can sustain in the early years.

Here are some steps to take now if you want to strike out on your own sooner or later.

Crunch the numbers

How much does your life cost you right now? The really streamlined version, where you pay all your bills, put some money aside into savings, and have a modest amount of discretionary money.

Now tack 35% to 40% onto that number, because that streamlined budget is just the starting point. You'd probably need to earn more to account for your own health care, taxes, and other daily or business expenses. Does that figure seem reasonable? Scary? Can you figure out how you might get there?

Start working a side hustle

The lowest risk way to get started as a freelancer or otherwise self-employed person is to establish yourself while earning a steady paycheck. Start picking up gigs on the side in order to build a stable of clients in advance. Of course, that only works if your day job isn't going to fire you for side hustling, so be sure to check your employee handbook.

Build your runway

The scariest part of transitioning from a steady paycheck to freelance life is the variable income. Some months you will be "flush with cash," in the words of Jean-Ralphio from "Parks and Recreation," while other months will leave you questioning your decision to become a freelancer.

In order to minimize the potential damage of the slow months, you should build up a runway now. At the very least, you want six months worth of living expenses in your emergency savings fund. Depending on your risk tolerance, you may want an emergency savings fund, plus a "starting out as a freelancer" savings fund to help you handle those fluctuations.

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Simulate the self-employed experience

One of the best things I did before going freelance was simulating the experience in advance. I was working a full-time job and doing both freelance writing and speaking engagements on the side. About three months before I was going to take the leap into self-employment, I switched to putting my entire day job paycheck into savings and then practiced living and budgeting with my freelance income.

Doing this boosted my savings accounts and gave me a taste of life on a variable income.

Figure out your health insurance

Steady paychecks are nice, but health insurance is often what keeps so many people tied to a traditional employer. You need to figure out how you're going to secure health coverage and factor that into your monthly budget. Talk with other self-employed people you know about what has worked for them. Do some research about which plan would be the best fit for you based on your age, where you live, and your current medical needs.

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Once you're ready to start working for yourself full time, here are a few more smart money moves to make.

Create a business checking account and pay yourself a salary

Your business income needs to be kept separate from your personal money. That's mostly for tax purposes, but also to make life easier. Consider paying yourself a salary out of your business account. It's great for your mental health, and it's smart, since paying yourself a salary can reduce the impulse to overspend during good months.

It's also important to know that many companies pay on a "net-60" or even a "net-90" period. That means you might not get paid until two to three months after your work is done.

Don't forget about quarterly estimated taxes

Your whole tax experience is about to change: The IRS doesn't want to wait a full year to get your money, and you also need to pay a self-employment tax because you don't have an employer paying into Social Security and Medicare on your behalf. Depending on how you structure your business, you may also need to pay fees, such as an LLC fee.

Rarely will taxes be taken out of your freelance paychecks, either. It's on you to set money aside and to pay your taxes quarterly instead of annually.

The self-employed taxes rule of thumb is to set aside 30% of each paycheck for Uncle Sam. I put 45% of every paycheck into a separate account for taxes so I know I'll have enough to pay New York City, New York State and federal taxes. Then I also have money left over for my LLC fees and plenty to put into my SEP IRA, which ensures I'm still investing for retirement.

Come up with a retirement plan

Say goodbye to the perk of an employer-matched retirement fund. There are plenty of great things that come with being your own boss, but it also means watching out for your own ability to retire.

There are lots of options for freelancers, including a Roth IRA, Traditional IRA, Solo 401(k) and a SEP IRA. In your first year of self-employment, I'd challenge you to try and max out a Roth IRA, which would mean putting away $6,000 in 2020, or $500 per month.

Invest in your network

Finally, it's important to take the time to invest in networking opportunities. Whether that's asking someone to meet for coffee or going to conferences, networking is one of the ways freelancers can build and flourish in their careers. You want to have a community that will refer you for jobs. You also want people with whom you can talk shop and who also understand the pain of trying to explain your job at a cocktail party.

I look forward to welcoming you into the self-employed club!

Erin

Erin Lowry is the author of "Broke Millennial," "Broke Millennial Takes On Investing," and the forthcoming "Broke Millennial Talks Money: Stories, Scripts and Advice for Navigating Awkward Financial Conversations." You can find her at BrokeMillennial.com, Twitter, and Instagram.

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