So you wanna be a consultant . . .
I got my first consulting job in 1984. My ex-employers decided they were wrong in shutting down the UNIX project and laying us all off, so they restarted it. Because none of us was dumb enough to go back to work there again, I was asked to bid on a project to train people in UNIX and C. They wanted a flat-price bid, so I figured out how many hours it would take and bid it assuming 1.5 times my old hourly rate (hey, it was like overtime). Needless to say, I got the bid. The project came in on time, right on the budgeted hours, and they paid promptly.
I didn't make anywhere near 1.5 times my hourly rate on the project.
I made just about every financial mistake a new consultant could make. Since then, a lot of time and experience have gone by. I'm now a full-time consultant with a collection of regular clients who pay a lot more than 1.5 times my old hourly rate. This article talks about some of the lessons learned along the way.
As I write this, it's a few days until June 17, when I have to pay my quarterly taxes. If you've never had the joy of doing this, imagine having to go through all the normal IRS tax stuff five times a year. Four times a year you must make estimated tax payments that approximate what your employer would have deducted from your salary had you been employed. The fifth time is when you have to do your taxes for real (and no, timing won't permit you to merge the fourth estimated payment with your real annual return).
It's been my unpleasant experience that people get "good-paying" consulting jobs, then find that they're making less money than they did as a regular salaried employee. This comes from several common errors.
To make the example work, we'll assume that you're currently in a salaried position at $50,000 per year, and your goal is to make $100,000 per year as a consultant. We'll assume you're currently paying $7,000 in income taxes and $3,000 in Social Security, so you're clearing $40,000 a year. I've deliberately picked simple numbers to make the math easy, but the numbers we get below are reasonably accurate. (But your mileage may vary, a point to which I'll return.)
So let's say you get a consulting job and earn $100,000 per year. Your income taxes are now $7,000 plus 28% of the additional $50,000, or a total of $21,000. Your income doubled, but your tax bill tripled. It doesn't much matter if you like this or not-it's the way progressive taxation works, and that's what we have here in the US and many other countries. Feel free to complain, but do it to your congressperson rather than me.
The bottom line: you're paying $21,000 income tax, $8000 Social Security, and $2,900 Medicare. This comes to $31,900, bringing your take-home pay to $68,100. In exchange for doubling your gross, you get only a 70% increase in take-home pay. But don't get happy yet; things are going to get worse.
If you've got a real job, your pension will likely be much better retirement than Social Security. But if you're self-employed, there's no pension waiting for you. Fortunately, the federal government has made some very nice provisions allowing the self-employed to build pension plans for themselves. Keogh plans, IRAs, and others are easy to set up. See your favorite accountant for some recommendations of financial planners, set one up, and fund it.
The government allows you to put up to 15% of your pretax income into a retirement account. Because of some various jiggery-pokery, it actually winds up being only a shade over 13%. If you're at all serious about consulting as a career, you should be contributing the maximum, especially if you're young and healthy. Compound interest is your friend, and if you don't start until you're 40 it's damned near too late. So get an IRA or Keogh, and put 13% of your $100,000 into it.
Congratulations. Your $68,100 just became $55,100. And your 70% take-home increase is now 37%. But you're probably going to do much better than the corporate pension plan. For one thing, you vest instantly. For another, it moves with you from place to place and just keeps growing.
But that's not all you need. Whether you have a family or not, you need to think about disability insurance. As a consultant, you get nothing from workmans compensation or long-term disability through your employer. My insurance agent says that one person in five goes on extended disability for some period of their lives. If you're a young single person who can live with parents if a disaster happens, you might want to risk it. But if you're the primary earner for a family, it's not a smart risk.
If you have a family, you'll want to consider some additional term insurance and some whole life. You can get incredibly good deals through IEEE or the ACM, but it's still an expenditure.
Obviously, costs for this level of security vary wildly, depending on your age and circumstances. But for the purposes of our discussion, let's assume your annual insurance plus new medical costs are $7,100. This takes the $55,100 down to $48,000.
Congratulations! Your 100% increase in gross salary is now a 17.5% increase in your take-home pay.
If you take a full-time contract with a large client, you've effectively removed yourself from the job market. When the contract is up, you're going to be unemployed. Because you've been out of the market for a while, it's going to take some time to get a new placement.
It's also possible to work for a large number of small clients on retainer-type bases, so that as clients come and go, the demand stays fairly steady. But it will take a while to build that stable of clients, and in the first few years, you can go through some really lean times.
The upshot of this is that either way you shouldn't assume you're going to work 40 hours a week all year. In the beginning, assume it'll be more like 30 hours a week, or 1,500 hours per year. Later, you can adjust based on what happens in your real life, but you're never going to get to 40. You still want vacations, holidays, and those week-long trips to USENIX and LISA. It's a safe bet that you'll use about five weeks a year on those items, so assume you'll max out at 36 hours a week.
Now the math is easy. At 30 hours per week 52 weeks per year, you have to charge $65.00/hr to make $100,000-and remember, you're still only taking home 17.5% more than you were before.
Beyond this point things start to vary wildly, depending on your circumstances. What I want you to be aware of with the above example is that there are bears in the financial woods, and some of them are damned expensive bears.
You'll also want some good accounting. I swear by (not at) QuickBooks, but that's not all you need. Good tax accountants save you far more than they charge and give much more accurate advice than your Uncle Joe (or me) about what is really allowed and what isn't. Trust me, it's money well spent.
You're also going to need to keep current in your field. That means books, conferences, and maybe training. If you don't live nearby, your cost to attend LISA or USENIX and take one tutorial will be around $1,250. Again, it's all deductible, but it still adds up.
You'll also probably spend more on books and documentation than you used to. Assume at least $500; my spending is more like $2,000.
Our example consultant is now spending $3,000 to $4,000 per year on expenses-not a lot, but even after tax savings, it still takes $2,000 to $3,000 off the bottom line.
At some point, you'll answer the question of how much you must charge in order to make consulting worthwhile for you. If you've got customers ready who'll give you the right number of hours at the right rate, great! Welcome to the biz. If not, you've got some tough decisions to make. Is your problem coming up with the client base, or is it that the clients you have aren't willing to pay what you need? And don't just look at the numbers you need to make your minimums. Look at what happens if you miss by 10% or even by 20%. You might need to stick to moonlighting for a few years until your skill set and client base are bigger, or until you've got enough savings to endure some wild income swings. Or it could simply be that consulting isn't for you.
For the past three years, the total amount I've paid in taxes, Social Security, and IRA funding comes to 36.8% of taxable income-considerably better than the numbers shown here. But we are homeowners, and that alone makes a huge difference in income tax.
Most of our medical insurance comes through my wife's employer, but not all of it. When I was employed full-time, my employer covered the rest. Now we must cover that additional cost ourselves. We've also got two children, which drives up the medical costs. All together we spend about $3,000 on additional health, life, and disability insurance.
Taking all the additional costs into account, we determined the minimum gross income needed to hold steady. Assuming I could bill 1,500 hours per year, it came to $50 per hour. But that wasn't good enough. If we were going to assume the additional risk and worry of having one of us self-employed, it had better be worth it financially. Working that through, it came to $60 per hour, or about 2.3 times what I was making hourly before the change. Once I had the client base to support it, I said goodbye to my day job and have only rarely looked back.
These days we make our goal numbers easily. To get stability, I try to keep any single client from becoming more than a third of my income. Whenever the billable hours creep near 1,700, I raise the rates. This always makes a client or two drop off the bottom, but the increased rate makes up much of the difference. Over the course of a year, the lost clients are usually replaced, so for the last three years, I've had a $5 to $10 increase every year.
So we're now doing quite well, thank you. I'm able to do a few non-paying things just for fun-like writing this article. But it took eight years to move from the first consulting job to going full-time with it and another four to get to the point where I no longer worry about where the next client is.
Consulting can be lucrative, and it can be fun. But it's not something you should go into without a solid understanding of what your finances are and how they'll be affected. This article is at best an overview, one I hope will give you a healthy dose of caution. Start by looking at the issues raised here, but don't go ahead based only on those issues. Invest some time and money in a tax accountant or financial planner. There are lots of good ones out there; find your favorite consultant and ask him or her for recommendations.
And best of luck.