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Quitting Your Day Job? The Basics on Benefits Coverage for Entrepreneurs

Quitting Your Day Job? The Basics on Benefits Coverage for Entrepreneurs
Credit: Aysezgicmeli/Shutterstock

When you trade in your full-time day job to become an entrepreneur, you lose more than just your salary. When you hand in your two weeks' notice, you should also be prepared to lose benefits such as PTO, health insurance and 401(k) plans.

"Many of us do not fully understand the cost of benefits when we work for someone else," said Alice Bredin, founder and president at Bredin, a research and consulting firm focused on small businesses. "Double-digit annual increases in these costs are not uncommon, so business owners may struggle both to find an affordable solution that meets their needs and to pay for benefits as the costs increase."

The true cost of being an employer – even if you are your only employee – is staggering, and it's important to prepare for these financial obligations before you hand in your letter of resignation. Here's what you need to know about covering benefits and tax-related expenses when you're self-employed. [See Related Story: How to Start a Business: A Step-by-Step Guide]

You know those federal and state tax deductions that come out of your paycheck? Your employer splits those taxes with you, so when you strike out on your own, your tax obligations will increase significantly if you hire people.

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"Many entrepreneurs are shocked when they realized the true cost of bringing on an employee," said Ed Suarez-Solar, an attorney with Gunster law firm. "[There are] payroll taxes, the employer's share of Social Security and Medicare taxes, workers' compensation insurance, and the state unemployment tax."

Joel Klein, CEO of BizTank, suggests hiring an accountant or having an individual session with one before you hire an employee.

"Before you hire an employee, make sure you either understand the basic tax rules and obligations, or at least have an accountant you can go to if you have questions," he told Business News Daily. "Once you hire an employee, payroll taxes become a huge factor in increasing your tax obligations."

Even if you're operating solo, you'll still have to pay the self-employment tax. If you've freelanced or done independent contracting work on the side before, you're probably familiar with this: At tax time, you owe the IRS a portion of your net earnings for the year to cover Social Security and Medicare.

You may be able to deduct some of this, but it's a good idea to set aside money from what your business brings in to avoid a big dent in your cash flow when you file taxes. Visit the IRS website to learn more about how the self-employment tax works.

When you set out on your own, you not only need to figure out business insurance, and Jeff Somers, president of Insureon, said before purchasing business insurance, you need to understand your industry's risks.

"Every industry is different and so are the risks that an entrepreneur might face in their particular industries," Somers told Business News Daily. "For example, accountants will want to consider professional liability insurance in case a client files a lawsuit, claiming there was a costly error on their tax return. Restaurant owners are more likely to need general liability for slip-and-fall accidents."

Along with business insurance, you need to get insurance for personal coverages, including medical, dental and life insurance. Corporate employers typically offer this insurance, and it's trickier to navigate when you're self-employed.

Unless you're covered under a parent or spouse's plan, you'll need to do some comparison shopping and secure your own coverage. Forgoing health insurance to save money, even for a short time, is very ill-advised. The Affordable Care Act currently dictates that individuals may be penalized up to 2.5 percent of their household income if they do not carry coverage, Suarez-Solar said. (Note: Starting in 2019, Americans who forgo insurance will no longer have to pay a fine to the federal government. However, some states have passed their own individual mandate laws.)

Paul Davidson, director of human resource services at Paychex, believes that disability or income replacement insurance should be a big priority for entrepreneurs, but noted that underwriters are concerned about the risks associated with providing disability insurance to new business owners.

"Entrepreneurs should be prepared to put the time and resources required into finding the right disability policy," he said.

Health plans obtained through HealthCare.gov can be quite expensive, but as a self-employed business owner, you may be able to deduct premiums for yourself and your dependents on your tax return, said John Swanciger, CEO of the online small business community Manta. If your primary source of income is freelancing, another option is to join the Freelancer's Union and purchase insurance – among other benefits – through the organization.

The money in your retirement savings account can roll over from plan to plan. Converting from an employer-sponsored plan to an individually maintained one isn't difficult or expensive (beyond administrative fees), but if your employer had a contribution match rate, you will have to think about whether you can afford to make up the difference.

"Many well-established companies match their employees' 401(k) contributing rates – a luxury that isn't possible for a self-employed person," Swanciger told Business News Daily. "However, the good news is that an individual 401(k) or solo 401(k) works the same as traditional retirement plans offered by larger companies."

There are many retirement plan options available, but things start to change once you start hiring employees. It's important to look for a plan that best suits your business's growth strategy, Klein said.

If you have employees, you can set up a Simplified Employee Pension (SEP) retirement plan, which allows you to contribute to your own account and theirs, without the operating costs of conventional retirement plans. When you reach this phase, Davidson reminded business owners to research the compliance and regulatory measures that apply to employer-sponsored retirement plans.

"For instance, when establishing a 401(k) plan, the employer has to adopt a formal plan document and notify eligible employees about the plan, including who may participate and how it works," he said. "Plan participants must also receive regular notifications about their plan accounts and be notified of any significant changes in the terms of the plan."

For more information on retirement plan options for business owners and self-employed individuals, read this Business News Daily guide.

There are other unexpected costs once you become a full-time entrepreneur, and having an emergency fund set up could save you a lot of headaches, Klein said. "Having money in your savings that you plan to use to take on your business is one thing; having an emergency fund for outside expenses is another," he added.

Once you're an entrepreneur, you're also responsible for all your equipment, such as laptops, office supplies, printers and phones. You'll also want to research and develop a relationship with an IT specialist in case of equipment malfunctions.  

Bredin advised seeking insights from people who understand the business you plan on starting.

"One of the best ways to find out about all of the costs associated with running a company is to talk to an accountant who is familiar with the type of business you want to run," she said. "Attending events where business owners congregate can also be helpful. At these gatherings, you can speak to multiple business owners who may be willing to share the surprises good and challenging … of running [this] type of company."

Leaving your day job to pursue entrepreneurship is a big decision. Before you make the leap, you'll want to be prepared for the realities of self-employed life. If you're not sure whether you're truly ready yet, read the inspirational stories of how these entrepreneurs knew it was time to quit.

Additional reporting by Nicole Fallon. Some source interviews were conducted for a previous version of this article.

Saige Driver

Saige received her Bachelor’s degree in Journalism and Telecommunications from Ball State University. She is the social media strategist for Business.com and Business News Daily. She also writes reviews and articles about social media. She loves reading and her beagle mix, Millie.