Financial Roadmap for Employees Transitioning to Self-Employment

Deciding to transition from being an employee to self-employed business owner/freelancer/independent contractor. can be a significant life event. It can certainly be exciting as you relish the thought of greater freedom, flexibility and the ability to exercise your creativity in ways that you cannot when you are an employee. However, there is also a great deal of uncertainty, both professionally and financially. And while you cannot control the outcome, understanding where the uncertainty might come from will help you be much better prepared.

Prepare for Income Uncertainty

As an employee, you tend to receive a regular paycheque which allows you to systematize your living expenses. For example your monthly expenses such as your rent/mortgage, subscriptions, food expenses can be stable from month to month without really having to think about it. Being self employed often means that your income is irregular and unpredictable, especially when you first start your venture. Consequently, it is important to plan ahead for these fluctuations:

• Build an emergency fund where you can aim to save 3-6 months’ worth of living expenses before making the leap. This will provide a buffer during slow months.

• Open a separate bank account for your business to keep personal and business finances distinct. This helps with tracking income and expenses and simplifies tax filing.

• Set up a line of credit with your bank if possible that allows you borrow when cash flow is tight.

Budget for Taxes

One of the biggest changes when you become self employed is that taxes are not automatically deducted from your paycheque. Rather, you’re responsible for calculating and paying your taxes, which includes both income tax and for those of you who are registered, sales taxes.

• Make sure you save enough for your income taxes which includes federal/provincial income tax and payroll taxes such as contributions to employment insurance (EI) and Canada Pension Plan (CPP or QPP in Quebec). You can calculate your approximate taxes owing by using a tax calculator.

• If you are required to collect GST/HST (and QST in Quebec), you should ensure that this is transferred to a separate account or that you track this carefully.

• Depending on your income, you may need to make quarterly estimated tax payments (this will only happen after the first year of becoming self employed). These are essentially a down payment for your current year taxes.

Decide on Your Business Structure

When transitioning from an employee to a self-employed worker, you’ll need to choose a business structure. In Canada, there are essentially two structures: Sole proprietorship or Corporation. Each structure has different financial and tax implications:

• Sole Proprietorship: Easy to set up and operate, but there’s no separation between your personal and business finances, meaning you are personally liable for any business debts.

• Incorporation: Offers liability protection and potential tax advantages, such as paying yourself in dividends, but comes with additional administrative requirements and costs.

Understand Your Deductions

When you become self employed, you can take advantage of a variety of tax deductions to lower your income. Some common deductions include:

• Home Office Expenses: You can deduct a portion of your rent or mortgage, utilities, and internet if you use part of your home for business.

• Business-Related Expenses: This includes office supplies, software, professional services, and even travel costs if they are related to your work.

• Vehicle Expenses: If you use your vehicle for business, track mileage and fuel costs. You can deduct a percentage of these expenses based on how much the vehicle is used for work.

Manage Your Cash Flow

When you are self employed, you can’t always be sure when your next client or customer might come which leads to uncertain cash flow. As such, managing cash flow is essential and can be the difference between a successful venture and an unsuccessful one.

• Create a Monthly Budget that includes both personal and business expenses so that you know how much you will need each month and over several months.

• Identify your essential expenses so that you know what should be prioritized when cash flow is scant.

• Ensure that you save during months where you do have cash flow coming when possible at least until you have enough to cover several months of expenses.

Plan for Health and Disability Insurance

As an employee, your company may have provided health insurance and other benefits. When you become self-employed, it’s up to you to find and fund your own insurance:

• Health Insurance: While medicare covers most costs in Canada, there are certain costs such as dental benefits etc. that might not be covered. It is worth exploring available options for self employed people to bolster your coverage.

• Disability Insurance: It should be noted that when you are self employed, you are no longer entitled to employment insurance as you cannot be laid off by yourself. There is a plan offered by the government for self employed people for maternity and sickness benefits, however, premiums must be paid. Alternatively, you can compare the government plan to those offered by private insurers to see which one makes more sense OR you can build up your own fund.

Save for Retirement

As a self-employed individual, you won’t have an employer contributing to your retirement fund, so it’s important to prioritize saving for the future. Note that you will still be required to contribute to the Canada Pension Plan (this is mandatory) and as such will still have at least a small amount of income upon retirement:

• Set Up a Retirement Plan: In Canada, you can contribute to a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA). Aim to regularly contribute a percentage of your income to ensure you’re building retirement savings.

• Automate Contributions: Set up automatic transfers to your retirement accounts for consistent saving. Alternatively, you can transfer money manually depending on your budget for the upcoming months.

Track Your Finances

Managing your own business means you’ll be in charge of tracking your income, expenses, and taxes. Using accounting software or a spreadsheet can simplify the process and keep your finances organized:

• Choose the Right Accounting Application: A spreadsheet is fine if you only have a few transactions. Alternatively, if your business is more complicated, QuickBooks Online or Xero, are good choices. Software greatly simplifies the process of accounting and helps you to easily track expenses, generate invoices, and prepare for tax season.

• Keep Receipts: It is essential to keep copies of all receipts and invoices as they are required in the event of an audit as well as for your own reference. These can be maintained in a physical file folder or scanned and saved.

Consider Professional Help

Transitioning to self-employment can feel overwhelming, especially when it comes to taxes and legal requirements. In this case, you could hire an accountant who specializes in self-employment to help you:

• File Taxes Properly: A tax professional can help you take advantage of all possible deductions and avoid costly mistakes.

• Create a Financial Plan: A financial advisor can help you develop a plan for managing your business income, saving for taxes, and investing for retirement.

Moving from employee to self-employed doesn’t have to be difficult, but it does require an understanding of the risks and at least some advance preparation.

Looking for guidance on transitioning to self employment? I can help: