Financial Planning for Freelancers and Contractors 🏦 – Selfstart (2024)

Finances sit at the core of your business. Whether you are just starting off or are a seasoned freelancer or contractor, understanding how money works for you and your company is essential. That means understanding how much you earn, how much you owe the taxman, how much you can spend and how much is left for savings and investments.

It can be very tempting to jump straight into doing business without any sort of financial organization, but it can lead to some serious issues along the way. Unplanned tax payments, accounting costs, fines, and general overspending are only some of them.

It’s not just big companies that need to be on top of their financial game. Quite the opposite: you will most likely not have an accounting department or someone leading your finances to take responsibility for your money game, so you need to ensure you have a full understanding of your cash flow, your company money and how that is separate from your personal funds, your savings, your investments and — most importantly — the tax you owe.

The good news is, if you are ahead of the game and you plan accordingly, it can be a pretty simple process. In this article, I will take you through the basic steps of setting up your finances as a freelancer or contractor. Bear in mind, a lot of these subjects are heavily dependent on where you are based, but the high-level concepts apply to all self-employed people regardless of location.

Disclaimer: The following shouldn’t be regarded as financial advice, but rather opinions on how to set up your finances. You should always check with your accountant and/or financial consultant to figure out the right strategy for you.

Choosing between being a Sole Trader or forming a Limited Liability Company

Your legal entity is the first step you should look into when building your own business. The two standard choices will be declaring yourself as a Sole Trader (or forming what’s called a Sole Proprietorship in some countries) or forming a Limited Liability Company (LLC in the US, Ltd. in the UK,GmbH in Germany, as well asother name variants in Europe).

Limited Liability Companies usually come with slightly higher once-off and recurring costs than running a Sole Proprietorship, as they usually require you to hire an accountant to file your returns and deal with additional tax obligations.

In most cases, and assuming your income can cover basic accountancy costs, we recommend setting up a Limited Liability Company for your freelance/contracting business, for the following reasons:

• It’s the most tax-efficient way to manage your freelancing/contracting income. In most countries, having a limited company allows you to manage when and how you issue dividends and therefore, optimize tax accordingly.
• In contrast to being a sole trader, a limited company is an entity completely separate from you as an individual. This might sound insignificant at first, but if for any reason business activity doesn’t go as expected, you want to make sure that the debt and liabilities of the company aren’t carried over to you personally. As the name suggests, you are protected by Limited Liability. Whereas as a Sole Trader, you aren’t protected.

Can I start off as a Sole Trader and then form a Limited Liability Company?

Absolutely. There are a couple of reasons you might want to do that.

If you are in a country/state where the costs of a Limited Liability Company are hefty and your current income doesn’t easily cover your expenses, then it’s sensible to start off as a Sole Trader and then form a Company when your business starts to grow.

Finally, if you are still undecided as to whether you want to switch to freelancing/contracting permanently, testing the grounds by declaring yourself as a Sole Trader while you decide is also completely reasonable.

Now, let’s look at the second step, banking.

Banking Setup

While, if you choose so, you can simply use your personal account when you start your business, it’s advisable that you make a business account in order to separate personal from business finances.

I recommend opening two business bank accounts: a current/checkings account where you will receive client payments and use for day-to-day transactions, and a savings account that you will use for your company savings as well as the funds that will go towards your tax. You can split these into two separate accounts so that you are always on top of how much you owe to the taxman.

Accounting

Investing in a good accountant or accounting firm is essential. I can’t stress the importance of this enough.

People often get seduced by low rates, or simply think that accounting and bookkeeping is an insignificant part of their business and not worth investing a lot of money into. This couldn’t be further from the truth.

The number of people I know that have had to pay extortionate fines due to accounting errors is truly never-ending.

Here are some tips on finding a good accountant:

• Ask your network for referrals. Make sure to understand if the peers you are asking have been working with the specific individuals or firms long enough so that they have a well-rounded opinion.
• Look for online reviews and suggestions by people that are relevant to you. Check freelancing and small business forums in your country for recommendations.
• Look into hiring an accountant (or firm) that has experience in your industry and type of work. For example, if you are contracting as a developer, finding an accountant that specializes in tech contractors
• I would also recommend going with a firm that uses modern accounting software that will keep track of your income, taxes, dividends, invoices and so on. Most accounting firms these days use software like Freshbooks, Quickbooks, Sage or Xero, while others even build their own proprietary solutions.

Finally, here is what you should expect in terms of services:

• An accurate and up-to-date calculation of your corporation tax, income tax and VAT on demand. This can sometimes be accessible to you by the software you will be using, otherwise, you should require it as a monthly report from the firm you are using. Keeping on top of your TAX and VAT should be your first priority when it comes to your company’s accounting.
• Timely notifications about tax obligations, tax returns and filing your self-assessment.
• Accurate information on what types of business expenses you can claim and how.

Calculating your Income

When starting your business, it’s only natural to think that it’s a good idea to just withdraw all of your company’s net profits as personal income. After all, you have worked hard for these earnings, so why shouldn’t you enjoy them?

The main reason you want to avoid doing this and rather consider withdrawing a specific salary every month is so that youoptimize your taxes by staying under the higher tax thresholds.

The second biggest reason is that you want tocreate a buffer in case you have less income during a month, due to a client collaboration ending, you not being able to work, or other unexpected circ*mstances.

It’s always a smart move to keep some savings in the company as a safety net of funds. Later on, you can figure out the best way to invest these savings so that you can make your money work for you. But I’ll get to that in the Investment section.

Salary and Dividends

In most countries and tax systems, there are two main ways of taking in income from your company: that is thedirector’s salary, anddividends, in the case that your company’s net profit allows so.

Depending on the country you are in, there is usually an optimal balance of salary and dividends you can withdraw in order to benefit the most from your tax allowances.

For example, in the UK 2018/2019 tax year, the optimal director’s salary is £8,141, while by issuing dividends of up to £35,000 one could benefit from the lowest tax brackets. By keeping the director’s salary low, one doesn’t have to pay National Insurance contributions, while making use of the lower tax thresholds that are in place for dividends.

But what if I would prefer taking a higher income?

You are the one that ultimately decides what your optimal income is depending on your preferred lifestyle. You will need to figure out what level income a) lets you live the life that you want while b) stays under the higher tax thresholds.

There are a plethora of online tax calculators depending on which country you are in, so make sure to experiment with the calculations and decide on what your salary and dividends should be.

And now that we have covered how you will be getting paid, let’s talk about what to do with the rest of your profits that are sitting in your business accounts.

Savings, Investments, and Pension

After you have figured out what is the right income you need to live your desired quality of life, you need to make sure that the funds that are left are being invested smartly. The three most important savings and investment vehicles for freelancers and contractors are the following: aninstant access high-interest savings account, a Stocks & Shares ISA (if you are in the UK), and a Private Pension (SIPP if you are in the UK).

Cash Savings, or Emergency Fund

The first savings account you want to have is an instant access Savings Account with a high interest rate. First, check whether your bank offers competitive interest rates if you open a savings account with them.

If not, use a bank comparison website (for example https://www.moneysupermarket.com) to figure out what’s the best savings account in the market. Currently, in the UK, you can get a really good interest rate of 1.35% (1.50% for the first year) with a Marcus account from Goldman Sachs.

How much should I keep in an emergency fund?

A good rule of thumb is 3 months of outgoings. That would be the minimum amount of money that can cover your essential expenses (housing and bills, groceries) for 3 months, assuming that you are unable to receive any new income.

Individual Savings Account, or ISA

If you are in the UK, you can greatly benefit from a special type of savings account called the ISA, or Individual Savings Account.

ISAs are offered both by banks as well as specialized financial bodies and are special types of savings accounts that benefit from tax-free interest up to a certain amount of money invested per year.

Benefits of an ISA

• You have a threshold of up to £20,000 a year that you can invest in your ISA without incurring any tax on the interest gained.
• Your money can be invested into cash, stocks/bonds or a combination of both.
• Your funds are almost instantly accessible, often without any fees depending on your provider.

Self Invested Pension, or SIPP

Your third most important investment option and the least flexible one would be your pension.

Benefits of a Pension Scheme

• You can invest your company’s gross profit directly into a personal pension without paying any capital gains tax or income tax. The current threshold for funds that you can invest in a SIPP in the UK is £40,000 per year.
• That money can be invested into cash, stocks/bonds or a combination of both.
• It’s a great way to achieve Financial Independence as you grow older, as it “forces” a great deal of discipline on your money-saving behavior.

Pension Drawbacks

• The biggest drawback with a pension scheme is that you aren’t allowed to withdraw it before a certain age unless you pay a (usually) hefty fine.

Automating your Income

Once you have calculated your optimal income level (Salary & Dividends), you need to set up a couple of automated transfers between your business & personal bank accounts. The goal here is to stop having to think about transferring money from your business to your personal account every time you get paid, but rather build a process that takes care of everything for you.

You will essentially start treating your company as if it’s a separate entity as if it’s your employer.

That way, not only will you save time and effort from micromanaging your funds, you will also ensure that you aren’t being reckless with how much money you are withdrawing.

Each month, you want to be doing the following:

• Decide on a payday. It might sound weird to have a payday as a freelancer/contractor, but it really will come a long way when it comes to your personal budgeting. For most people, this is either the beginning or the end of the month.
• Set up a standing order from your Business Account to your Personal Account on your payday. The amount should be the sum of your director’s salary plus your dividends for the month.
• Set up a standing order from your Personal Current Account to your Personal Tax (or Savings) Account. That’s the amount of tax that you owe, which you should calculate based on your income from Dividends and your Director’s salary.

Now, all you have to do is ensure there are enough company profits each month to cover your personal income. The rest will happen automatically.

Closing Words

Staying on top of your finances might seem daunting at first, but in reality, it isn’t as hard as it sounds.

More importantly, it’s something you should do sooner rather than later, as the earlier you optimize your financial setup the easier it will be.

We know that banking, accounting, payroll & investments might not be the most entertaining part of being a Self Starter. It’s a crucial one, however, and making some good decisions early on while automating a big part of the process is undoubtedly going to reward you in the long run.