Contracting as a Sole Trader: A good way to become less poor.

Interesting circumstances have come up where I've needed to take the plunge (well, at least dip the toes in) into becoming an independent contractor for my current employer. Previously I had been on a casual arrangement which suited me just fine as I was paid an hourly rate instead of a salary. However this is a bit of a murky gray area they weren't comfortable with since I was, and will continue to be working relatively regular hours. I'm not really interested in "permanent" work since paid vacation is never convenient to take, and does nothing to help my mortgage, plus I'm rarely sick more than 1 day a year.

Looking at the options was quite a headache at first. I could go independant as a sole trader or company, or use a contractor management company similar to past arrangements through recruitment agencies. Contractor management companies charge between 3-4% in "management fees" off my rate in exchange for providing insurance cover, and options to do stuff like salary sacrifice. (claiming various expenses pre-tax.) My current employer offered to extend their insurance over me for the duration of my contract, so contractor management companies just became a rather expensive option for pretty much nothing. Digging around for insurance I've found policies that are well under that 3-4% anyways.

A lot of people look to setting up companies and trusts to gain tax savings since sole traders treat all income as personal income. The company tax rate in Australia is 30%, where your personal tax rate average can edge up to around 40%+. However, the ATO (stingy bastages) love to make tax law around companies very complex, especially in the case where the company only has 1 employee / director. It essentially wants to ensure that a company structure for an individual contractor is complex and cannot easily be used to marginalize tax. Even so, under a company, any dollar taxed at the company rate need to remain "firm" assets of the company, even paid out as fully franked dividends (tax paid) franking only covers that first 30% so you still need to pay the difference in tax back to the ATO as the dividend is counted as personal income. Some people look to things like Trusts to spread out income among the family which I think works out well if you've got an unemployed partner, and lots of kids... Other than that it requires a lot of input from professional accountants who are probably dipping into gray areas of the tax laws.

The sole trader option is simple and free to set up, and in particular circumstances such as my own, it can be very lucrative. For instance, I am not well-off, I'm actually quite poor. Thanks to my mortgage I owe a bank a crap-load of money that will take decades to pay off. However, I do have an offset account where I can keep my funds liquid, having an effect as if they were paid directly against my mortgage. This means the more money I can get into my offset account early, the far greater impact that money will have against my mortgage's interest paid back to the bank. I do not pay any tax for this interest saving, and it's impact increases and decreases directly with my mortgage interest rate so it its inflation-proof. But the question is how can this work with a sole trader business model?

There are two very interesting factors to consider about the sole trader arrangement:
1) Sole traders are not required to pay Superannuation. (retirement fund)
2) Sole traders are responsible for paying their tax at the end of the tax year. (Or quarterly if the ATO gets shirty)
3) If you earn more than $75,000 per year you must register for and pay GST. (10% paid quarterly)

Superannuation is normally a compulsary 9% deduction off your rate that goes into a super fund which either earns you marginally more than your mortgage rate, (after fee deductions) doesn't, or even loses you money. (As has been the case for the last 2 years.) Honestly, the system the government imposed is a complete sham as Super brokers deduct significant fees regardless of whether the super fund performs well or not. Depending on how this arrangement works out I will consider looking at self-managed super fund options to get some benefit from the slightly lower tax arrangement offered for superanuation savings. In the meantime, that money can be better served paying down my home.

The fact that tax can be paid at the end of the financial year is HUGE. This is effectively turning your annual earnings into one big credit card with the offset account. Every penny goes into the offset account working against the mortgage until the end of the year when the tax office gets their cut. GST must be claimed on top of your agreed rate, and it is claimed by your client as an expense, but you collect it and pay it to the tax office every 3 months. For that time, it too is working against your mortgage for free.

To put it in perspective: If you're using a management company, with PAYG (Pay as you go) tax arranged (the norm) and you're contracting for $50/hour:
$50 - $4.50 (Superannuation) = $45.50 - $1.36 (management fee) = $44.14 - $15 (income tax) = $29.14 * 40 = 1,165.60 This is what is going into your offset account account each week.

As a sole trader: $50 + $5 (GST) = $55 * 40 = $2,200 is going into your offset account each week. Each thee months $2400 is deducted from the account to pay GST, and at the end of the year $30,600 (plus tax from super savings) or so is deducted for income tax. Your offset account would be left with virtually the same (depending on whether you make super contributions or not) but the key difference will be in your mortgage balance. That extra savings will be knocking off dollars more a day from interest charges quickly adding up to substantial savings on the final price of your home. (And if you want to put *that* into perspective, given a 30 year mortgage with no offset account, paying the bank's required repayments, and averaging out the interest rate, the final price of your home is roughly 2x your signing price, adjusted for inflation, 2.4x+ in today's dollars.)

This is how it can be used to make you "less poor". It wouldn't be nearly as effective at making someone who isn't in debt "more rich" since any interest gainings from investing that money until tax time is typically taxed itself, and adopts whatever risks your investment strategy incurs. Rest assured the ATO will want to collect its pound of flesh whether you lose money investing it's tax dollars or not. But less poor today = more rich later as your mortgage is paid down faster, which means more equity sooner.

Unfortunately, there is one snag with this model, and that is that much of the industry, particularly larger clients such as government, will not deal with sole traders. Insured or not. Still, my current client doesn't have a problem with it so I thank them for this opportunity, and will place great value on similar options in the future.