NerdWallet's Smart Money Podcast - What You Need to Know About Starting a Business Before You Quit Your Job

Starting point is 00:00:00 You just quit your job to start a business. Congrats. But before you spend that final paycheck, PTO, payout, and bonus, there's a lot to plan for. Today we're going to help a listener turn their entrepreneurial leap into a financially sound one. Welcome to Nerd Wallet's Smart Money Podcast, where you send us your money questions, and we answer them with the help of our genius nerds. I'm Sean Piles. And I'm Elizabeth Ayola. Now, today we're answering a question from Blake.

Starting point is 00:00:29 Thank you for sending in your question, Blake. And it came in by text about financially planning to start a business. Here's the question. Hi, NerdWallet. I have a question for the podcast team. My name is Blake and I am 27 years old living in Washington, D.C. I'm getting ready to leave my job and start my own business. Don't worry, my employer knows.

Starting point is 00:00:49 Ha ha. I'm wondering if you have any advice or tips on how to best manage my money after receiving my final paychecks, PTO payout, and I'm getting one final bonus check. too. Any insight on how to set myself up for success and any accounts I should plan on opening for the business would be great to know too. To help us answer Blake's question, we are joined by Rosalie Murphy, a small business writer at Nerwollet. Hey, Rosalie. Hey, it's so good to be here. Longtime fans of Smart Money will remember that we used to have you on quite a bit, so I'm really glad we can finally bring it back out to answer the listeners' question. It's so great to be

Starting point is 00:01:23 back. So it seems like Blake is doing things pretty right. They're planning ahead. They are thinking about how they should have a financial buffer when starting a business because many businesses actually are not really profitable, as I'm sure you will get into momentarily. But I'd like to hear your thoughts on how much Blake should have in their emergency savings given that they're entering a pretty volatile uncertain period in their life. Blake, first of all, congrats to you. This is a really exciting transition. I hope the next few minutes don't sound too intense. But that said, it's true that many business owners don't pay themselves much, if anything, for the first year. Many business owners have ups and downs in future years. The most recent data I could find from the Fed

Starting point is 00:02:04 about small business profitability was from 2024. But that year, 38% of businesses with no employees. So if you're thinking freelancers, consultants, et cetera, only 38% of those folks were profitable that year. And only 47% of businesses with employees were profitable. So this is a really tough thing that Blake is doing. And that's for all businesses, right? Not just new ones. It's even harder when you're establishing your customers or your clients at first. So your mind. My mileage can definitely vary here if you're starting out as a consultant and maybe you know a few clients from your personal network who are going to hit the ground with you right at the beginning. You'll probably get there faster than one of my fellow small business writers. Her husband opened a brewery last year, right, which is this huge capital intensive business that requires.

Starting point is 00:02:46 Not of overhead. Furnishing a space, hiring employees, et cetera. So that is a much longer runway. Personally, I'd recommend Blake have enough cash save to cover their bills fully for at least six months. and that would be on top of any emergency fund that they have, that could maybe be a little less if they're going to keep some kind of a part-time job or if they have a partner living with family, you know, they're splitting the bills with somebody. That could vary. Basically a year's worth of expenses is what you're recommending here, having that much cash in the bank. I'd say minimum six months. If you want to lean more.

Starting point is 00:03:18 On top of the emergency fund, which could be six months too. Yeah. So, yeah, if you want to be particularly conservative, I think a year is smart. Don't be like me. When I started a business, I had no savings. So I was fighting for my life. Yikes. That's terrifying, Elizabeth. What did you do? It was. It was. Well, I was broke, really, really broke. So there's that. Well, Rosalie, aside from having an emergency fund, what are some other financial buffers that Blake can have in place? I'm thinking right now of debt pay down before leaping into full-time entrepreneurship. I think that definitely depends on the type of debt if we're talking, you know, car pay, student loans, maybe Blake has a mortgage, that stuff to me falls into your bills, right? Just keep making regular payments using your cash savings, your emergency fund, the way that you've been doing that. When it comes to higher interest debt, like a credit card, I'd recommend trying to finish paying that down before you start a business. And that's because a lot of business owners

Starting point is 00:04:12 end up taking on additional debt to cover their startup costs to cover those first few lean months. And we don't want anybody to end up paying off more debt later than they're currently dealing with right now. Well, speaking of debt, I think something that entrepreneurs don't think about enough, especially its first time entrepreneurs, is taxes. And if you forget about those taxes, you can find yourself in debt to the IRS. And then a big part about entrepreneurship as well is if you're going from a W-2 employer who helps you with that tax bill, you're taking on that load yourself. So, Rosalie, how can new business owners plan for their new tax realities, keeping in mind that that varies depending on your business structure? Absolutely. Yeah, I have known so many free

Starting point is 00:04:54 freelancers who didn't realize that they needed to take on that portion of their taxes that employers are paying right now. And it's a really, really unpleasant surprise in the spring when you go to file your taxes. If you ever look at your pay stub, you see that there are a bunch of different types of taxes withheld, things like Social Security and Medicare taxes. You have to be responsible for those instead of your employer withholding those from your paycheck. And normally you pay half and then your employer pays half. When you're no longer on a W2, you're paying 100% of that liability. So and that's on top of your income tax, right? So what exactly Blake will owe depends on how they set up their business. But the long story short of this, if folks take one thing away from this conversation, do not just take all of your business revenue and send it into your personal checking account and treat it as your paycheck. It is not the same. In general, I think a good rule of them is to set aside 30% of your business revenue for taxes. And that's net revenue, which would be after you subtract out expenses.

Starting point is 00:05:49 That sounds like a lot to set aside. I imagine, especially if you're not even bringing in much money, that could be pretty hard to do. Definitely. And there's some tools that can make this a lot easier. One of the first things every business owner should do, and we'll get into this more later, but that's to open a business bank account and use this for all of your business revenue. Any money that you take in goes into that account. Any money that you spend on your business comes out of that account. That'll give you a much clearer picture of what your revenue actually is. And then you can transfer money to yourself when you have some leftover and that can kind of be your paycheck.

Starting point is 00:06:21 And that's actually not too difficult or different from actually shopping for another kind of online bank or getting a checking account, maybe even from your local credit union for your business, right? Yeah, most banks that offer personal checking accounts also offer business bank accounts. There are a variety of online options. To your point, lots and lots of brick and mortar banks and credit unions offer business checking accounts. Some actually have really interesting tax planning tools. There's a neobank or an online bank called Found that has a really useful suite of tools that will automatically flag. how much you need to be saving for taxes, kind of move that to an envelope, remind you when quarterly tax payments are due, things like that.

Starting point is 00:06:57 If that's a concern for any, you know, if that's something that is, feels really daunting to folks listening, I would definitely recommend keeping that in mind when you start looking for your business checking account. That's hard because I imagine when you're a business owner, there are so many things that you don't know that you don't know, like to your point earlier about holding enough aside for the IRS, so you don't get an overly nasty surprise tax bill later on. But having some software, live some of that administrative burden for you, could be extremely helpful. The other thing that can be really helpful with that, if you do want to

Starting point is 00:07:24 stick with your credit union, your brick and mortar bank that doesn't have those tools. Accounting software also usually has some version of tax planning tools where as long as you're tracking all of your income and expenses and when you set up that separate bank account, you can sync that with your accounting software and just make sure everything's correctly categorized. Again, that'll help you with that visibility. But that can help you understand how much you owe in taxes. I'm not an accounting software expert, but I consulted the folks on our team. We really like fresh books for freelancers. It's a little bit cheaper, a little bit simpler. I'm sure most folks have heard of QuickBooks, which is sort of the industry standard, but is a little bit more

Starting point is 00:07:58 robust and a little more expensive. Blake mentioned that they'll be getting a final paycheck, a PTO payout, and a bonus. I've never heard of a bonus for leading a company unless something wild has happened. So congrats Blake, that's a pretty sweet deal. I imagine they'll be receiving a good chunk of money all at the same time. I wonder how you think Blake or someone else in the situation should make the most of that. Should it all go into saving? Should it go into their business, maybe split it up? What are your thoughts here? I think probably split it up depending on their financial situation right now. If Blake is maybe in a position similar to where you were, Elizabeth, when you launched your business, that emergency fund is looking a little slim. A big chunk of

Starting point is 00:08:36 cash going into that account could be a great runway to keep paying your bills while you're getting all this infrastructure set up. If you're comfortable with the amount of money that's in there right now, maybe this is something that can go toward your startup costs. Startup costs are also something that can just vary a ton depending on what you're doing. If you need to rent or furnish a space versus if you're going to be working out of a desk in your home, every business will need at least a few hundred to a couple thousand dollars to cover things like licensing, insurance, setting up a website, that kind of stuff. I would recommend setting aside at least a few hundred to a couple thousand dollars to pay those initial bills.

Starting point is 00:09:13 Yeah, those bills really creep up on you. Every year I have a website and the renewal fee is like, oh, again, all of these fees really add up. important to calculate them ahead of time. All right, let's move on to retirement savings, Rosalie. What should Blake do with existing retirement accounts? This is something that sometimes people forget about or can be abandoned. Does Blake consolidate? What should Blake do? If Blake has an employer-sponsored retirement account, that's usually a 401K, right? It might be a 403B. You can't keep contributing that after you've left your job because it's employer-sponsored. But you do always have access to it. That money is still yours. It doesn't go away. I,

Starting point is 00:09:51 would recommend certainly saving your password, making sure your address is up to date on that account if they need to get in touch with you. Some people like to roll all their old 401ks into one account. I'm certainly one of those people. 401ks from previous jobs are now rolled up into my nerd wallet 401k just because I don't want to have to keep track of multiple. But that's up to you. But IRAs, and that includes Roth IRAs, are not linked to your job, right? Individual retirement accounts. So if Blake wants to keep contributing to that, they certainly can, as long as, you know, they're still following those rules about the maximum that you can contribute and making sure for a Roth that your income is still within the limits. Blake will also have access to some unique retirement accounts that are for business owners. Can you give us a run through some of those?

Starting point is 00:10:34 There's something called a SEP IRA, SEP, this stands for a simplified employee pension plan. This is an IRA just for people who are self-employed or own their own business. And it sort of works like an employer-sponsored retirement account, except your kind of both parties. So your business can make a contribution to that account, sort of like your employer contributing to a 401k. That's tax deductible. When you retire and you start withdrawing that money, those distributions are then subject to income tax. These have really high contribution limits, which could be helpful if your business, you know, really takes off. Again, your first couple years are typically, you're in the trenches for a little while. So I'd be surprised if most people are able to take advantage of that right away.

Starting point is 00:11:19 That's a really good point because sometimes people think, oh, I have a small business, having to open a step IRA and funnel a bunch of money into it. The money you put into that account is tied to the money that comes into your business. You can't just throw in your whole emergency savings into a set by IRA that's not how it works. Exactly. Yeah, this has to be money that shows up somewhere on your business's balance sheet, right? It's some sort of income that your business is earning. Guys, I'm thinking about a listener question we answered a while back, Sean, I'm sure you remember this one, and it was about budgeting during grad school.

Starting point is 00:11:50 Now, if Blake's income is lower during their first few years of business than it was as a full-time employee, then it could be an ideal time to do Roth conversions since they'd be in a lower tax bracket, right? Yeah, Elizabeth, that's a really smart idea. Because you will have a lower income bracket, most likely, if you are in lower earning years right after starting in business, you will just have to pay, Blanche. less in taxes than if you have a higher earning year because when you go from traditional to Roth, you have to pay income taxes on that amount that you're converting. So very clever idea, but again, consult a tax pro if you already do this because any tax bill, you just want to have someone with experience looking that over for you. Something else I want to talk about, Rosalie, going back to the idea of business and personal checking is separating the two,

Starting point is 00:12:34 because sometimes people can intermingle these accounts and that can lead to all sorts of messes, especially if you form an LLC. This could put your LLC protections in jeopardy. So, Rosalie, do you have some guidelines here so people can do the whole separate account thing in a smart way and not jeopardize any sort of business structure they might have in place? I think there's a sense that when you start an LLC, it's like you're putting on like the invisibility cloak from Harry Potter and it makes you completely anonymous. And that's really not true. What an LLC does, LLC stands for a limited liability company. and that creates a separate entity, like something that the IRS and the legal system sees as a separate entity from you and your personal finances.

Starting point is 00:13:16 The purpose of that is to limit your personal liability. So if your business is ever sued or taken to court for any reason, and it doesn't really matter if you're kind of found liable or not, right? Court is still not a cheap thing and not something we want to do. Ideally, the court sees the LLC as completely separate from you and the only assets that are on the line are the LLCs. assets. If you do not have that really strict separation, the court could try to say, you know, these really aren't two separate entities. This is called piercing the corporate veil. I love that term, by the way. It feels like something out of like a fantasy novel. It's very dramatic. Yeah. If you're going to set up an LLC, you want to take as many, you know, take lots of precautions to make sure that nobody can accuse you of having pierced

Starting point is 00:14:01 the corporate veil. So this means separating your business and personal finances basically as completely as possible. So think everything you have for your personal finances, you need another one for your business. So number one, you would apply for something called an employer identification number or EIN. This is sort of like a social security number for your business. It's the ID number that the IRS will use to keep track of you. It's required if you have employees or if you ever hire employees. It's free to get one on the IRS's website. You can do it basically instantly. I will say if you get an EIN, keep track of that number because speaking from an experience, with my own LLC, I misplaced and forgot my number.

Starting point is 00:14:42 And so it's okay. But I was calling all around. There were some articles that I read on the internet that misinformed me saying I could just call my bank and they'll be able to tell me what it is. But just like you can't call your bank and say, hey, what's my social security number? They're not going to give you your EIN over the phone either. So I had to go in to the brick and mortar location. Thankfully, my credit union is just down the street.

Starting point is 00:15:03 I could do that pretty easily. but keep track of all of this stuff. Recordkeeping is very important when you own a business. A hundred percent. And then once you have your EIN, you can use it when you're applying for a business checking account. It's not required, but something helpful to have. And then that's another place where that record will be kept. If you use credit cards and you want to apply for a business credit card, I think we'll talk about that a little bit later, but that's an option. You may also need insurance for your business. This is another part of protecting your finances, especially if you're going to be driving at all for work, your personal auto insurance might. exclude things that happen when you're driving your car for work. Take a moment. Think through all of the things that are involved in your personal finances. There's a good chance you need one for your business. So I know we've briefly spoken about incorporating a business.

Starting point is 00:15:50 And not every business needs to be incorporated. But I find sometimes new entrepreneurs get confused about whether they need to do it or not. But we know that a lack thereof can impact your personal finances if you're unlucky and hit with a lawsuit. So Rosalie, how can new business owners protect their personal finances through incorporating the business or any other means? I know you mentioned insurance. Anybody who earns money for themselves is technically a business. Anybody who gets a 1099, I used to do some freelancing before I got to NerdWallet. When I would go to file my taxes, I was always surprised that whatever software I was using would say, these are your business taxes.

Starting point is 00:16:26 I was like, I don't have a business. But whenever you're earning income for yourself, the IRS sees you as a business. right. So if you don't create a separate entity like an LLC, you're called a sole proprietor, lots of relancers, side hustlers, consultants fall into that category. But that can put your personal finances at risk if your business ever gets sued. So for that reason, we do typically recommend incorporating. I think the LLC is by far the most popular way to do this. This is a popular choice because of those legal protections, right? So if somebody ever sues you, assuming you're diligent about keeping your personal and business finances separate, Only the LLC's assets are on the line, not your personal savings or your home if you own one, your car, all of those assets. There are also a bunch of other corps, like a C-Corp and an S-Corp, and this can get a little confusing and easy to mix up. Can you outline those? Yeah. So you can also create a partnership or a corporation.

Starting point is 00:17:19 So C-Corp, S-Corp, there's also a limited liability partnership. These are all taxed differently. I would recommend talking to a lawyer if you are considering any of these entities. they are a little bit more complicated, and the paperwork required to set one up is a little bit more involved. An LLC is typically just filing articles of incorporation with your state. I'll throw out there too, since we don't want to go to in the weeds here. If you would like to see the different types of business structures out there, we will link an episode description to an article where you can see a breakdown of all the different business structures.

Starting point is 00:17:50 And Elizabeth, I was going to say not to air your business, but you do this all the time anyway. You've already mentioned this in the podcast, but you recently switched to an S-Corp, right? Oh. Well, not recently anymore. It's been two years, maybe three now. But yes, I started out as a sole proprietor, then I did an LLC. Then I went to an S-Corp as advised by my tax person because everyone's situation is different. I remember maybe my third year in business, I was hit with like a $10,000 tax bill. And I was like, whoa. Luckily, I had savings. Yeah, but, you know, my tax person was like, hey, you know, if you have an S-Corp, then that could help lower your tax bill. So I changed it over and it has indeed lowered my tax bill. When you're an S-Corp, that means you can put yourself on payroll, whereas if you're an LLC, all of the business's profit is sort of considered your income. So once your business starts doing really well, once those profits go up, if you're an LLC, that means your income goes up, right? And you're taxed more versus a court makes it easier to keep it in the business. Yeah. So S-Corp does have his expenses. So payroll is one of them. And you may end up paying your tax person a bit more because they're going to charge you more for managing an S-Corp versus an LLC. But I find that the benefits outweigh the cons. So again, it's about what works best for you. Definitely want to emphasize talk to your tax person to make sure you understand the pros and cons for your specific situation. But I want to circle back to the other thing you mentioned, which is insurance. So just like in your personal life, businesses need insurance too. We recommend that basically every business have something called

Starting point is 00:19:14 general liability insurance, which protects you against lawsuits in general. This is where you see like a classic slip and fall lawsuit, which is somebody got injured visiting your business or whatever. Another very common thing that you may need is professional liability insurance, which you'll need if you are giving advice to clients. So if we're going into consulting or something like that, I would definitely recommend professional liability insurance. This will protect you if a client sues you and says, you did a bad job. You made a mistake and that affected me later. Check on your car insurance. If you're going to be driving frequently for work, your personal auto insurance may deny a claim by saying business use isn't covered. So there's commercial auto insurance as well. most of the same major carriers that do personal, also do business auto. Let's talk about business accounts. This is something that I very quickly realized was important, as we briefly mentioned earlier, because I was commingling my personal finances with my business finances, and it was a mess during tax time because I'm looking through my personal statements,

Starting point is 00:20:17 trying to figure out what was my own money and what was my business money. But anyway, I did end up opening a business account, which now I put all of my business expenses in. What are some things that people should consider when they're opening a business account, Rosalie? It's a lot of the same things that we think about when we're looking at personal checking accounts. So does it charge a monthly fee or is there a minimum balance that you need to maintain to avoid a monthly fee? With a business account, I would definitely recommend checking on fees for things like wire transfers or making cash deposits. You may be in situations more often. If you're working with like a vendor or a supplier where you're paying via ACH or wire a little bit more than you

Starting point is 00:20:54 what in your personal life. We talked a little bit already about some of those software tools that business bank accounts use. So that can include things like tax planning. I'm also starting to see more business bank accounts offer things like the ability to send invoices to a client and take a payment directly through the bank's payment processing systems. Some will let you take tap to pay credit card payments in the bank's app. So if you're, you know, vending at a farmer's market or over the weekend I went to the Renaissance Fair, right? And I did some tap to pay. That might be something that's useful for you. A couple of accounts will pay interest on checking account balances. That's relatively rare, but never hurts to get, you know, 1% interest or so if you can. We have a bunch of

Starting point is 00:21:34 resources for this on Nurt Wallet's website, which hopefully we can throw in the notes as well. I want to throw one more thing out there, minimum balance fees or requirements. As a new business, you're not sure when you're going to have money and when you're not. And there have been months where I had no money and thank goodness I wasn't charged any fees because I'm, I picked a bank that doesn't charge me fees for that. So think about that as well. Yeah, that's common, especially with big national brick and mortar banks to require a minimum balance of usually it's like one to five thousand dollars. And if you fall under that, you'll get hit with a fee of maybe 15 bucks per month, which may or may not sound like a lot of money, but it's certainly annoying if you didn't expect it.

Starting point is 00:22:12 Well, let's talk about business credit cards. I've passed on these so far for my business. I get plenty of offers in the mail that go straight into the recycling bin. Do you think that they are necessary or not? Are they nice to have? What do you think? I definitely don't think they're necessary. If you're a person who prefers not to use credit cards in your personal life, you definitely

Starting point is 00:22:32 don't have to use them for your business. But they are useful in a couple of ways. Number one is probably the biggest pain point. I hear from small business owners is at the beginning. The cash flow just isn't there. You have all these expenses. There's so much that needs to be done. Credit cards are one of the easiest ways for new businesses to access financing.

Starting point is 00:22:50 It's really, really hard for a brand new business to get a business loan. So a credit card is, you know, kind of a flexible line of credit. Although you will be paying for that with a high interest rate, I assume. Yes. I would definitely not recommend, like, funding your entire startup on a credit card, both because of the high interest rate and because even though it's for your business, and even if you formed an LLC or a separate entity, you are going almost always going to have to sign a personal guarantee, right?

Starting point is 00:23:14 Which is a promise that if your business can't pay back whatever you owe, that you personally will pay back. whatever you owe. So if you open up a credit card and then your business just never finds its customers, it never takes off, and you're left with whatever your startup costs were, you're still on the hook for that. So that fancy metal credit card you get in the mail is going to tear right through that corporate veil. Yes. Well, no. Okay. So corporate veil is intact, but the finances you're on the hook for it. Yes. So the bank or the credit card issuer still wants its money back, right? If they lent you $10,000 and you used your credit card to furnish your space or whatever the case might be with

Starting point is 00:23:54 your startup costs, right? And you get to a point where your business just can't pay that back. Typically, when you take out a business credit card, you have to sign what's called a personal guarantee. The card, they just won't issue you a card if you don't sign a personal guarantee. I see. That said, there are some useful things that business credit cards do. If you have a 0% APR intro period, just like personal credit cards do, these are usually a little bit shorter for business cards. usually up to 12 months, but that can buy you a little bit of time with no interest to build up that cash flow. The rewards are pretty similar. We see cashback business credit cards with, you know,

Starting point is 00:24:29 cashback of 1 to 2 percent, higher cashback rates for certain categories. The other thing to think about here is that just like you individually have a personal credit history and a credit score, your business has a credit history and your business actually has about a dozen different business credit scores or it'll develop them over time. We don't need to get it. to all of this today. But business credit is important for in the future qualifying for business loans, establishing trade lines with suppliers. I've heard people say that if they're kind of a retail vendor and they're trying to get into a major national chain, that national chain will pull their business credit because they want to make sure that they kind of made good on their word in the past.

Starting point is 00:25:08 Most business credit cards report your payment history to the business credit bureaus, just like personal cards would to the personal credit bureaus. So if that's something on your mind, business credit cards are one of the easiest ways to start that process. One last big area to touch on is health insurance because, you know, our listener here is not going to have access to their former employers, health insurance. And I imagine it's going to be pretty expensive on their own. How do you think that Blake can plan for health insurance when they are starting their own business? Yeah, this is a big one and this is usually the toughest conversation I have to have with people in my life who want to start a business. Health insurance

Starting point is 00:25:47 on the private market is really expensive. I've bought marketplace insurance before, and it was, I mean, it was expensive 10 years ago. I know they said they're 27, so too old to be on the parents' plan, but if they're married and their spouse has health insurance through work, that might be the cheapest option and to get on that plan. Leaving your job is a qualifying life event, so you are allowed to change coverage mid-year. Your spouse would be allowed to change coverage. You can also buy private insurance so we can go through the healthcare.gov marketplace and compare your options, or you can work with an insurance broker. Rosalie, we've covered so much.

Starting point is 00:26:19 If you had to sum up our conversation and give the top three to five things that an entrepreneur should do before they leave their job, what would it be? I think it always comes back to that North Star, which is separating your business and personal finances. It's going to make your life easier. It will protect you legally.

Starting point is 00:26:37 It'll make tax time way easier. Everybody needs a business bank account. Think through whether you want to incorporate. If this is going to be your primary source of income and you are hoping to build this into something. I generally recommend forming an entity rather than remaining a sole proprietor. Everybody needs some kind of business insurance. I'd recommend a business credit card if you can qualify for one. That mostly depends on your personal credit score. If your FICO score is in those good or excellent ranges, you probably have a lot of

Starting point is 00:27:03 options. And then lastly, make sure you understand how your business will be taxed. If you're a sole proprietor, if you're an LLC, if you're an S-Corp. We've talked about this. We all know lots of people, I think, who didn't go into this with a full understanding of how their business would be taxed. And that's fair because it's really complicated. But I don't want you to get hit with that really, really unpleasant tax bill. One last thing to mention about taxes, technically when taxes aren't being withheld from your paycheck, you're supposed to make quarterly payments to the IRS. I'm sure smart money has covered this many times. Put those dates on your calendar. It's the 15th of April, June, September. in January, just so you make sure that you're making even approximate payments on those days.

Starting point is 00:27:45 All right. Rosalie, thank you so much for all of this. I know that we add a lot of questions for you, but I think that they'll really help Blake and anyone else helping me start a business and do it well. That's awesome. Thank you so much for having me on and good luck, Blake. Okay. In a moment, this week's money news.

Starting point is 00:27:59 Stay with us. Time now for our weekly Money News Roundup where we break down the latest in the world of finance to help you be smarter with your money. Today we're talking about prediction markets. You probably seen the names, Kalshi and Polly Market by now, I certainly have. Trading volume on these platforms has exploded over the last couple of years, but they're still in this kind of weird regulatory gray zone between trading and betting. To learn more about what comes next for prediction markets, our news colleague, Anna Hilhouski,

Starting point is 00:28:30 spoke with Aaron Klein, a senior fellow at the Center on Regulation and Markets at the Brookings Institution. Aaron, welcome to Smart Money. Thank you, Anna. It's a pleasure to be on. Well, let's start really basic because many people, may have seen ads for Calioree or Polymarket, but don't really know how it works. How do prediction markets differ from stock trading and how do they differ from gambling?

Starting point is 00:28:50 Let me explain what a prediction market is and then we can discuss how they're different and similar to the two things. A prediction market is based on a binary event outcome happening. So something is either going to happen or not. And each contract settles usually at $1 for whether something will happen or won't. And so if you buy something at 50 cents and say it will happen, then that's essentially a chance to double your money, just like a straight odds bet at a casino, or if a stock doubles in value if it happens. And if it doesn't happen, it goes to zero. So one thing to know about prediction markets is you're making a decision on an event, and that is either going to pay off in full or go to zero. So unlike a stock, which rarely, generally companies don't go all the way to zero.

Starting point is 00:29:45 That does happen sometimes when they go bankrupt, but they kind of go up or down or fluctuate a little bit. A prediction market is an event contract on a binary outcome. It's either going to happen or it's not. It's similar to gambling in the sense that a lot of what prediction contracts are written on are sports bets. The majority of Cal She's business is sports. betting is sports. Now, whether it's betting or not, to me, if you're betting on who's going to win the Yankees game, whether you do it on draft kings or you do it on prediction market, it's gambling in terms of you're betting on the outcome of a sporting event. But legally and economically,

Starting point is 00:30:26 there are major differences in doing it through a prediction market than doing it through a sports book. And the types of people that can access these types of contracts are also different, which include some people who have been generally legally barred from gambling. From a regulatory perspective, what's its stake in the distinction between being a financial product versus being a gambling product? Massive. This is monumental distinction. So let's start with first, are you allowed to do it? Right now, gambling is the pervience of the states. 46 states have lotteries. Four do not. Many states allow sports betting. Many do not, including California, Texas, Georgia. some pretty big places. So if it's a financial contract, then it's federally regulated. It's a federal

Starting point is 00:31:15 situation. And the states have a much more limited role, particularly they cannot tell you no. There's no state that can tell you you can't buy a stock, for example. So the first thing is that it is allowed everywhere. The second big difference is how old you are. In order to gamble, in every state in America, you have to be 21. But to buy a state. stock or a bond or a prediction market contract, you have to be 18. People who are 18 to 21 can go on Cal Shee but can't go on draft kings. If you call it a financial contract, you're eligible for teenagers, older teenagers, younger 20s. If it's called gambling, you're not. Three, taxes. This is critically important. If you win money at a casino or on a sports betting

Starting point is 00:32:05 platform. You pay taxes like earned income. 1099 is the form, but it's just like any type of earned income. But if you win it through a prediction market, that's considered a capital gain. Capital gains are taxed lower than income for many people, particularly the wealthier you are. I think it was a giant, ugly bill. Some people think it was more attractive. But one of the things that that Trump legislation did in cutting taxes for the wealthy was it reduced your ability to offset gambling losses. Prior to the Trump tax law, if you bet a lot of money at the casino and you broke even, you didn't pay any taxes. Now, you can only deduct 90% of your losing. So if you go in one day and you win $100 and you go in the next day and you lose $100, it used to be, well, you didn't

Starting point is 00:32:58 pay any taxes. Now you can only deduct 90% of your losses, $90, off the $100 you gain, so you owe taxes on the $10 you won. That creates a tax liability that makes gambling even more disadvantage from a tax perspective, which doesn't apply at all to prediction markets. So those are the three big differences. The role of states, teenagers, and taxes. There are many others, but those three, I think, are pretty significant. There is active litigation right now between states and these platforms. Where do you think this ends up? Does it get resolved in court?

Starting point is 00:33:36 Does it need Congress to actually legislate? I think it ends up in the Supreme Court. You're already seeing different circuit courts apply laws differently, come up with different rulings. Minnesota just lost a case, whereas I think Nevada won a case. So the courts are disagreeing, and this is a big enough and topical enough issue that I think it ends up in the Supreme Court. A better outcome would be congressional legislation.

Starting point is 00:33:59 A better outcome would be Congress making a decision. Congress has already given the Commodities Future Trading Commission, CFTC, who regulates futures, which is what a prediction market is. They've given them the authority to ban it. In fact, some people in Congress say they really wanted it banned. And the CFTC for many years did not allow these types of things. It's only under this new Trump administration that the, these have been given the green light to go wild. So right now, the regulator has the authority

Starting point is 00:34:31 to shut it down. It's choosing not to. It's choosing to promote it actively. And it would be nice for Congress to come back and say, no, no, we actually didn't mean this to happen. Or by all means, do it. But here's a group of legal distinctions that cover a bunch of things that prediction markets really are struggling with. The definition of insider trading. Do we really want a tax advantage? prediction markets on sports gaming as opposed to traditional sports books. What is and isn't allowed? There are a couple things that aren't allowed, but I mean, could you bet on high school sports?

Starting point is 00:35:08 Could you bet on referee outcomes? The regulators made some choices there, but those choices can be unwound by another regulator. Ideally, Congress will come in and settle this. In the absence of that, I think the Supreme Court will eventually hear some of the big picture issues. And are there any safeguards in place to prevent someone who has insider access, a government employee, an executive, a contractor, et cetera, from turning confidential

Starting point is 00:35:31 information into a bet and making a profit? There are, they're minimal. And when you say safeguards in place, the question is, what isn't legal? The laws that we've defined about what is insider trading are very much based on the idea of public companies and public assets. And what we're talking about here are events and moments. There seems to be a different scandal every day, right? But one of my favorite ones occurred in France.

Starting point is 00:36:00 There was a prediction market question on how hot it was going to be in Paris. If you read the fine terms of the contract, the high temperature of the day was considered the reading at noon at Charles de Gaulle Airport. And this person figured out that where the thermometer was that took the reading was not in a secure part of the airport. And so what this person allegedly did was make that wager, drive to the airport with a portable blow dryer, go right under the thermostat at 1158, heat it up, and then run away at noon so that the official noon temperature showed a sudden spike. That doesn't seem like a fair bet, right? No, it doesn't. Does not. Right?

Starting point is 00:36:48 Was that insider trading? I mean, was it market manipulation? What was the exact rule that was being violated? The president's teleprompter guy was recently caught by the firm making wagers about things related to Trump. Well, you know, Trump follows the teleprompter until he doesn't. So are there safeguards in place? There are some, but I think they're radically insufficient. The law is not well defined here.

Starting point is 00:37:17 Or put a different way, the law was defined for a type of insufficiency. insider trading that isn't applicable here as it relates to these situations. Now, the 2026 midterms are already a massive prediction market event. And I saw earlier before this recording that Polymarket has Democrats as the favorite to retake the House with millions of dollars traded on that single contract. What worries you most about how much money is sitting on live elections? The prediction markets like to say that politics is such a big market for them. Their big market is sports.

Starting point is 00:37:50 Still sports. Even as the midterms get closer and closer and closer, it will dwarf compared to what an NFL weekend will do. So make no mistake about it, this is primarily about sports. A lot of times when you look at these election contracts, I'm worried less about the big dollar ones than the small dollar ones. I'm worried more if people are writing things about state delegates in Omaha because those are much more thinly traded. and much more manipulable. In areas where you don't have much public polling, where you don't have much information,

Starting point is 00:38:26 there's a desire by a lot of people to support and vote for the winner. And the ability to manipulate a market by creating the appearance that something is going to go in a certain direction by dumping a lot of money. It would be very hard to manipulate who's going to win the midterms in the house.

Starting point is 00:38:44 You're following this so closely. Are there other developments as far as what comes next for prediction markets that you'd like to point out? There are. Number one, prediction markets have entered into what's called the parlay market. So it was one thing before, whether I was going to tell you the Yankees were going to win or lose. Now it's, will the Yankees win and Aaron Judge hit a home run? Now, this is really mimicking a sports wager. Some people would say, well, bars want to hedge against the risks of the Yankees winning or losing because they're going to make a free promotion or something that's a little

Starting point is 00:39:18 trickier to say, I mean, I tend to think you're pointing to the tip of the tail of the dog to justify the, you know, decision about the rest of the animal. Here, though, I think you're starting to really ask yourself, are you just mimicking sports books and why? Why are you mimicking? Well, sports books tend to be more profitable off of parlays than off of simple wagers. People just tend to overestimate the probability of multiple events occurring or more precisely their own ability to predict multiple events occurring. And so generally you see things wanting to go more in that direction on the prediction market side, which I think kind of belies the fact that this is heavily sports gambling. The second thing is prediction markets say, well, look, unlike a casino

Starting point is 00:40:03 where there's a house, we don't take a position. We're just mirroring for people on contracts both sides. Every buyer has a seller. Yes, that's true. Every buyer has a seller. But they're also market makers, they're often on the other side of this large hedge funds and other private investment vehicles that are on the other side of the contract. So don't think that you're trading against another person. You're often trading against a pretty sophisticated, algorithmic, large money entity on the other side. And if there is one thing that you want people to keep in mind the next time they consider using one of these platforms, what would it be? We as an Economists distinguish between investing and entertainment.

Starting point is 00:40:51 Gambling is considered entertainment. Gambling, some people really enjoy it, they have a good time, but as entertainment, it's going to cost you money in the long run. Very few people are profitable gamblers. That doesn't mean gambling's wrong. It doesn't mean gambling isn't fun. There are lots of forms of entertainment that our society allows and promotes. Investing, you're expected to make money.

Starting point is 00:41:18 Investing is about having a long-term horizon and putting money away now that will grow for the future. And just understand the distinction between gambling for entertainment and investing for the future. All right. Aaron Klein, senior fellow at the Center on Regulation and Markets at the Brookings Institution. Thank you so much for coming on. Thanks for having me. And that's all we have for this episode. folks to send us your money questions, you can call us or text us on the nerd hotline at 901-7306373. That's 901-730 Nerd. Nerd. You can also email us at podcast at NerdWallet.com or leave us a comment on Spotify or YouTube.

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