What is your opportunity cost?
Daytime landscape view of people walking near Shinjuku Eki (Photo credit: Infradept)
In my last post in this series, I talked about becoming a freelancer, and some of the things we have to consider. Why would someone become a freelancer? Is it feasible for someone of average means? How much money do you need to survive?
Another important point to consider is the opportunity cost: How much do you give up by pursuing self-employment? First, you need to evaluate what you have, both tangible and less tangible. For this post I’ll use the example of someone making a base salary of $60,000 gross from their employment plus benefits and a bonus, and someone making a similar amount from self-employment. I will calculate estimated total federal and provincial taxes using the Canadian Income Tax Calculator.
Working for the man
The grass isn’t necessarily always greener on the other side of the fence, and there are benefits to working for the man. For one, you usually only have to do your 37.5 to 40 hours, and for two, you get some additional benefits that you’d have to cover yourself, if you were working for yourself. Here’s a hypothetical employee making $60k plus benefits and bonuses, paying taxes as if he lived in Ontario:
| Base salary | $60,000 | |||
| Plus: 8% bonus | $4,800 | |||
| Plus: 5% RRSP match | $3,000 | |||
| Plus: Insurance benefits* | $1,000 | |||
| Plus: Cell-phone plan* | $800 | |||
| Plus: Gym membership* | $250 | |||
| Total gross income | $67,800 | |||
| Total gross income including benefits | $69,580 | |||
| Taxable gross income | $61,800 | Hours worked/week: | 40 | |
| Less: Combined income tax | $12,703 | Commute: | 10 | |
| Less: Canada Pension Plan | $2,217 | Total | 50 | |
| Less: Employment Insurance | $1,176 | Total gross/hour (49 weeks/year) | $27.67 | |
| Net income | $51,704 | Net income/hour (49 weeks/year) | $21.10 | |
| *Estimated |
Let’s go over each item:
- Base salary: He makes $60,000 a year.
- Plus: 8% bonus: It’s been a good year for the company, so he gets an additional $4,800.
- Plus: 5% RRSP match: He’s been a diligent saver, and the company rewards him by matching his retirement contribution, for an additional $3,000.
- Plus: Insurance benefits: The estimated value of what he would have to pay for his private insurance.
- Plus: Cell-phone plan: The company provides him with a phone and plan.
- Plus: Gym membership: The company also provides him with complimentary gym access.
These are the rewards he gets for working at the company. Add it all up, and it comes to:
- Total gross income: $67,800. This is how much cash he receives from the company.
- Total gross income including benefits: Add in the value of the benefits, and it’s around $69,580 in total compensation.
- Taxable gross income: He has to pay taxes on the $67,800 in cash, minus $6,000 for his retirement contributions.
Subtract the various tax items and he is left with $51,704 in net income. He gets three weeks of paid vacation per year, so his before-tax hourly wage, including commute time, is $27.67/hour. After tax, it’s $21.10/hour. If he wants to freelance, he needs to match or beat these hourly wage figures.
Working for yourself
There are benefits to working for yourself, too. First, you no longer have to face rush hour, and though you can choose to do your 37.5 to 40 hours, you can also do more. You have a lot more flexibility when it comes to taking vacations or time off, though you have to pay for the time yourself. Working for the man gave us $67,800 in cash, and $51,704 in net income after taxes, insurance, cell-phone plan and gym membership expenses. The taxation situation when working for ourself is slightly worse, but as you will see, it is not that bad:
| Total gross income | $69580 | Less: Insurance | $1000 | |
| Less: Combined income tax | $10059 | Less: Cell-phone plan | $800 | |
| Less: Total CPP | $4434 | Less: Gym membership | $250 | |
| Less: Employment Insurance | $1176 | Less: Transportation | $1000 | |
| Less: Insurance | $1000 | Less: Other business expenses | $5000 | |
| Less: Cell-phone plan | $800 | Less: Employer CPP | $2217 | |
| Less: Gym membership | $250 | Less: Retirement contributions | $6000 | |
| Net income | $51861 | Taxable income | $53313 | |
| Hours worked/week: | 47.5 | |||
| Commute: | 2.5 | |||
| Total | 50 | |||
| Total gross/hour (49 weeks/year) | $28.40 | |||
| Net income/hour (49 weeks/year) | $21.17 |
Total gross income: $69,580. He has to earn a little bit more cash if he’s working for himself, since he gets no benefits. Since our freelancer has to cover his benefits himself, we assumed that he had to earn a total gross income of $69,580. Let’s go over each item again:
- Total gross income: $69,580. Our freelancer has to work a little bit more to get back to the same point of income.
We’ll then calculate how much tax he would pay, on the right-hand side of the table:
- Less: Insurance: He’s paying his own insurance, now, and this is deductible.
- Less: Cell-phone plan: He pays for his own cell plan.
- Less: Gym membership: He pays for his own membership.
- Less: Transportation: This didn’t even show up in the other table, as employees cannot usually deduct their transportation expenses to go to & from work.
- Less: Other business expenses: As a business, we can deduct other expenses incurred in the operation of our business.
- Less: Employer CPP: Self-employed people can deduct this cost from their income.
- Less: Retirement contributions: We’re still going to put the same $6,000 toward our retirement, which will help us save taxes.
- Taxable income: Once you add in all the deductions, our taxable income is $53,313. This is less than in the employment case, but as you will see, the tax effect will end up a wash.
Now we calculate our actual net income by subtracting our tax payable, pension contribution, employment insurance, and the benefits which we now have to pay for, ourselves. After we all that all in, we end up with a net income of $51,861. As you can see, it’s pretty much a wash. We started with a similar amount of gross income and ended up with a similar amount of net income, whether working for the man or working for ourselves.
How much does a freelancer need to earn per hour?
When our example was working for the man, he grossed about $27.67 for each hour spent at work or in traffic. If he works for himself, he will have to gross about $28.40 per hour over an equivalent amount of time. Since he does not have to spend as much time in traffic, this means he has to earn about $29.89/hour for each hour spent actually working, if he still wants to take three weeks vacation a year and earn about the same yearly income after tax!
But he now has to work 47.5 hours a week to get to the same place!
Fair observation. If he worked only 40 hours a week, he’d need to gross $35.5/hour. However, although this is a fair observation, this is not a fair comparison. When he has to commute to a job, he has to eat up 50 hours total of his time. Therefore, you should compare apples to apples and use the same amount of time when working for yourself. Our freelancer also has a lot more flexibility, and ways he can increase his income:
- He can work more. When you are working for yourself and enjoying what you do, there are no issues in doing 50 to 60 hours, or even more.
- He can earn more. There is no reason why our freelancer has to stay at $30/hour gross for the rest of his life. There may be more opportunities to diversify and increase income.
- He can save more. No need to eat lunch out every day, or pay as much for transportation. Sure, there are expenses incurred in running a business, too, so it may be a wash, but it’s still a point worth considering.
I have not even gone into the value of the intangible benefits, such as not having to ask for permission to take vacations, and being able to work on what you choose. As with many things in life, the decision is not black & white, and there are pros & cons to both sides. There is also no reason why freelancing and the corporate life can’t overlap, especially if you end up working for your own company. 🙂
Dear reader, have you ever run the numbers? What would it look like for your situation? I imagine that as salary increases at work, it becomes harder and harder to take a leap. If our employee was earning double, his gross requirement would then be $60/hour. However, this blog is meant for everyone and not just people earning large salaries, and the truth is that most of us are not in that situation. Even if we were, it’s also possible to get there as an entrepreneur or freelancer.
As always, I would love to hear your thoughts. 🙂
I’m always impressed with your use of numbers Investitwisely. It makes things so much clearer when arguing a case. I am trying to emulate your accurate technique. But money isn’t everything: I had a sort of similar situation where I had the choice between a job in my hometown and so I would live with my parents, or a better paying job in London where I would have to rent. I had to run the numbers and figured that I’d save and extra £10k a year by staying at home but I wouldn’t have the social life, independence, or networking opportunities as I would have in London, which is why I chose not to move back home.
Definitely, money plays a part of the equation but is not the whole picture. We have to evaluate all the intangibles and look at the big picture, too. At the same time, it does help to know how things look on the money front.
London is quite expensive to live in, eh? I imagine that you’d need a few more bucks an hour if freelancing there 😉
There’s definitely a lot to be said for working for oneself. However, while there are benefits, there are also challenges to being your own boss. One of those challenges is the financial budgeting and income analysis that is associated with it. I commend you for thorough factoring all of the numbers. I need to get on the ball, and start doing this myself.
Hi Anthony,
Definitely agree, both lifestyles have their pros and cons. It’s not a black & white choice, and there are many things to consider about both paths.
Great breakdown of real numbers! I was always curious how much benefits break down to so your numbers are really interesting. I think the stress of providing all of these things for myself would be enough to keep me from ever wanting to freelance – I think I like working for “the man”. Most of the time anyway…
Working for the man isn’t all bad. I could be sitting on my butt now and collecting an easy salary. 😉 It’s all about trade-offs, though — I listen to my friends complain about this or that at work, and I’m glad I don’t have to face that. I don’t even feel the need to complain, even though I’m not able to relax as much as them, because I know my destiny’s in my own hands.
I seem to recall once reading that a basic rule of thumb is 2.5 times your salary. Do you think that’s reasonable?
Nah, I think that’s totally excessive, especially if you have some savings. All that really matters is that over a period of 6 months or more, your income averages out to a rough equivalent of your day job. Given a long enough period of time, a day job is just as unstable, unless you work for the government or union. Even that is not a given. 😉
These numbers are good. The problem is a freelancer has to not only make ‘x’ amount per hour, but also needs to stay busy for 40+ hours per week while making the target amount per hour. Losing a client could be a major problem for a freelancer while not having a full 8 hours work might get absorbed by “the man”.
I would think the hourly target wouldn’t be as difficult as it would be to ensure that there was enough business.
Very good point. Maybe you make $50 an hour and have a work load of 60% so you end up around the same target. We probably shouldn’t look at it in terms of making $X amount per hour worked, because it doesn’t quite work like that, but over the long run that’s the target we still need to hit.
I’ve never seen a 37.5 hour work week. Is that a Canadian thing?
I basically take my annual after tax money I need to live a happy life, and multiply by 1.3X to equal the amount I need to make.
e.g. I can live comfortably on $70,000 after tax a year, hence $70,000 X 1.3 = $91,000 gross income a year. That’s the ball park.
Keep the math simple!
Sam
Hey Sam,
Isn’t life grand up here? Some (and by some I mean “more than a few”) have a 35 hour work week!
It’s fine to keep the math simple, but it’s also important to understand the finer aspects and details. Otherwise you’re just making stuff up without really understanding why. That said, nothing wrong with a 1.3x rule, and I think that’s completely reasonable as a heuristic.
I don’t know how others feel but for me working for someone else is like slavery and would like to quit it as soon as I could afford. If I make a little less in freelancing; no problem. But working for someone else. OMG! it is like hell.
Haha, I know what you mean! It’s really not just about the money, but also about the freedom.
I thinking running through the real numbers would be the first step of this plan. I really liked how simple you laid it out. You show exactly how it will be and therefore you know what needs to be done. Great way to keep it simple and easy to understand.
Glad you liked it, Miss T! 🙂
Terrifically thought out article Kevin! Very pertinent for me as I just completed my first ever freelancing job 😀
While this is a great analysis of a one year comparison, I’d be curious to run these numbers over the course of a career. Someone could walk into a $60,000/year job right out of school, whereas building a freelance business to that income level would likely take many years in a lot of fields. That said, the freelancer could have much higher earning potential long-term if the business takes off. It really could go both ways depending on how well the business succeeds.
I think it pays to have both types of experience. I took a job out of graduation, and was able to gain a lot of experience through that. In fact, that’s how I got into the mobile industry. 😉 Sometimes people limit themselves in their thoughts because they see the world too much in black & white. You can take both paths.
Working for the man, for a lot of people, is much easier. I think that’s why less people are brave enough to try freelance work. My husband and I are both self-motivated workers, so I think we will do well in our endeavors. I hope so anyway! Great job on breaking down the nitty gritty numbers! Very interesting indeed.
Working for the man definitely has its benefits. I don’t want to come across as saying that freelancing is “better” or that there’s something wrong with working at a job. It comes down to priorities, and the world isn’t black and white. There’s nothing to be afraid of on either side of the fence. 😉
Kevin, I like the way you are laying out the analysis for all to see. I’ve never freelanced in Canada so not sure what it is like.
Doesn’t seem so bad in terms of paperwork / taxes!
I haven’t run the numbers myself, although as I’m making only $12000 US per year currently (no benefits, alas; I have to cover my health insurance and retirement, on top of everything else), it wouldn’t take much to match my income via a side project. I still haven’t managed to master the delicate art of making my side projects profitable. I suppose, though, that if I am going to make such a jump, now is the time to do so, before I would have to match a higher income. Ah, well, perhaps in the near future.
The lower you need, the easier it is to freelance, and the more freedom you have. The truly rich have the same freedom as they won’t blow it all on status objects, unless they truly have the means for it!