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New approach key for self-employed


YOU'VE HARVESTED an entrepreneurial spirit and launched your own business. Or you've given up the 9-to-5 grind and - like 10 million other people in the United States, or about 7 percent of workers - rely instead on contract and freelance work.

Either way, welcome to the ranks of the self-employed. Your personal finances will require a whole new approach.

Estimated tax payments. By far, the biggest adjustment is paying personal income tax as a self-employed worker.

Unlike employees whose taxes are deducted from paychecks, you are responsible for calculating and mailing in your tax obligation. So a check issued for $1,000 is not all yours to keep, and you must pay what's owed Uncle Sam regularly throughout the year.

"What most people don't realize is that we are a pay-as-you-go tax system," says John W. Roth, a federal tax analyst at CCH Inc., a tax software and information provider. "For the self-employed, that means having to file quarterly returns."

Internal Revenue Service Publication 505 explains how to make estimated tax payments. Fail to make them and you'll owe all of your taxes for the year when you file in April, plus interest and penalties.

Generally, you should set aside between 30 percent and 40 percent for payments, depending on your state's income tax rates.

That percentage may seem high, but independence comes at the cost of self-employment tax: about 7 percent in additional Social Security and Medicare taxes that employers normally cover.

Deductions. Working solo, you'll incur business expenses that can be subtracted from your total earnings, reducing your taxable income.

Qualified deductions will vary by profession, which is why many self-employed professionals meet with a tax preparer for help.

To claim a deduction, you need proof of the expense.

"Get backup - a receipt - for every dollar you spend, whether you're buying a computer or a blouse," says June Walker, a tax and financial consultant to self-employed professionals, based in Santa Fe, N.M. "Most new self-employeds don't have an idea what's a business expense and what isn't."

Insurance. Because there's more to life than taxes, also consider how to replace benefits, such as health insurance, that an employer may have provided.

If you're married and your spouse is covered under an employer-sponsored plan, see if you can be added to the policy.

Singles should check out whether a professional association offers group coverage for members.

If all else fails, look for a high-deductible individual plan.

A recent study by eHealthIn found that premiums typically cost $50 to $100 monthly on plans coupled with Health Savings Accounts, in which you deposit money into an account to pay for medical expenses.

To qualify for an HSA, a plan's deductible must be at least $1,000 for singles and $2,000 for families. Contributions to your HSA are tax-deductible and withdrawals for qualified expenses, such as doctor's visits, are tax-free, helping alleviate your upfront costs.

Retirement accounts. Even though you no longer qualify to participate in an employer-sponsored 401(k) plan, there are other tax-advantaged plans for retirement savings.

Among them: individual 401(k)s, SEP-individual retirement accounts (IRAs) and Simple IRAs, all of which let you defer a portion of your pay before tax or take a deduction for contributions. Savings also grow tax deferred.

But contribution rules vary. For instance, you (as your own employer) can shuttle up to 20 percent of compensation into a SEP-IRA, capped at $42,000 in 2005. With a Simple IRA, both employer and worker can make contributions equal to either 100 percent of compensation or $10,000 this year, whichever is less.

To learn more, visit Web sites of major mutual fund companies or go to www.401khelpcenter. com.

When you're flying solo, it may seem like you need to hang on to every penny. But with such contributions, "at least you reduce self-employment tax," says David Bergmann, a financial planner in Marina del Rey, Calif.

Maybe taxes are everything, after all.

E-mail Carolyn Bigda at

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