The Biggest Trap Facing New Entrepreneurs


In a tough economy, millions of Americans have taken on contract positions in lieu of permanent employment, while many others have unleashed their inner entrepreneur by seeking to start their own businesses. But in doing so, many don't realize some of the hidden dangers that can newly self-employed people right where it hurts most: in the wallet.

The Pros and Cons of Self-Employment

It's no surprise that the number of self-employed workers has risen dramatically in recent years, rising to more than 22.1 million, according to the latest available figures from 2010.

With traditional jobs harder to come by, many people have had no choice but to strike out on their own. Even those fortunate enough to have jobs are often underemployed and can use a self-started business as an outlet to take full advantage of their talents.

Being self-employed, however, is a lot different from having a regular job. On one hand, you get a lot more flexibility in deciding how you do your work. Many workers take advantage of self-employment to build flexible schedules that fit with the rest of their lives.

But they're also on their own to cover a bunch of costs for which employers usually pick up the tab, such as office equipment and supplies.

A Taxing Proposition

One of the biggest extra expenses you'll have to cover is the self-employment tax. With regular jobs, your employer withholds a portion of your paycheck to cover Social Security and Medicare taxes, and then contributes an equal amount of its own money to pay the total tax liability.

Because being self-employed means being both worker and employer, the self-employment tax is roughly twice what gets withheld from your paycheck as an employee, with a 13.3% rate applying in 2012 up to just over $110,000 of income.

%Gallery-151688%More importantly, it's your responsibility to make sure you get your self-employment tax paid, usually on an estimated basis every quarter. If you don't, you could end up owing significant penalties and interest.

When you combine self-employment taxes with the regular income taxes you'll also have to pay, the bill can be quite large, amounting to a third or more of whatever money you receive.

Don't Get Blindsided

The biggest danger with self-employment tax liability is letting it get ahead of you. As long as you know about the tax, it's a lot easier to protect against that danger. But if you don't, it's easy to fall so far behind that it's almost impossible to catch up.

Learn more about self-employment taxes from the IRS website here.

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Motley Fool contributor Dan Caplinger has been self-employed for six years now. You can follow him on Twitter @DanCaplinger.