The Business of Freelancing – Saving For Taxes
This is the first day of our series on The Business of Freelancing. Every day this week we will have a new tip to help you make the most of your freelancing career.
Whether you’re getting started or just want to optimize your freelancing business, don’t miss this series thanks to Shane from ShaneandPeter.com.
You are deciding to become, or currently are freelancing. Let me tell you right now, in the eyes of the government, you are a business owner. Your odds of success increase dramatically if you see yourself that way and behave accordingly.
If you ask the IRS, the purpose of running a business is one thing, and pretty much one thing only – to make them money. They expect business owners to keep careful records (or pay someone else to), worry about things like profit and loss, and offer services and/or sell goods.
Saving for Taxes
Whether or not you realize it, your employer paid approximately 15% on top of your wages to the government for the honor of having you work for them – I hope you were worth it =) . This is called payroll taxes.
As an independent contractor, you are now responsible for covering this cost on top of your normal tax burden. Keep in mind that when you were an employee, your employers paid your income tax before you ever saw a pay check. As a result, many new freelancers never really think about having to keep money for taxes.
If you live in California like we do, save somewhere around 35-40% of everything you make and put it away for next April 15th. Don’t even think of it as your money – it’s the government’s. I promise you, nothing hurts worse than a $20,000 – $50,000 dollar tax bill when you have spent it all. I recommend doing some tax planning and asking a CPA for the proper percentage to put aside based upon your expected earnings.
Why do I put aside such a high percentage? Because it is hard to know exactly how much I will need to pay before the year is over, and whatever you don’t have to pay Uncle Sam is all yours. For the last few years, I had between 5 – 30k left over after paying the tax bill. This has been a great savings mechanism for my family. One year we bought some furniture. Last year we put the money in an IRA for retirement. No matter what you decide to do with your leftover tax money, you’ll be 100% better off than the guy who doesn’t save at all. If you are like me, you’ll rest easy knowing that if the IRS decides to pay a little audit visit to your *business*, you’ll be in the clear.
NB. This information should augment, not replace advice from an accountant or lawyer. This information is mostly relevant to US citizens. While we would like to include information for more localities, because FreelanceSwitch readers hail from all over the world this cannot be accomplished.
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There are a lot of University students who do freelance work and when I mention the word taxes they become confused. I’m very scared for those people who didn’t do the math. Thanks for sharing this information!
Thanks for the tip! I met with the family accountant at the beginning of the summer using some of my projected numbers- it seems I will be going over, which is great, but will hurt when Tax Season rolls around. This seems like a great convention for saving.
Kristen:
Thank you for the eye opening article on Tax savings. Yes, most of us don’t think about taxes when we collect checks, and at the end of the year repent not doing that on time.
Rajesh shakya
http://www.rajeshshakya.com
Helping technopreneurs to excel and lead their life!
How does saving up and paying in April compare to making estimated payments quarterly? Because of a mess-up with my tax paperwork at my full-time job last year, I found myself owing a couple thousand dollars in taxes, which is bad enough, but then just barely escaped paying “underpayment penalties” for not having paid enough from my paychecks (I had just started the job in the fiscal year before, and underpayment is allowed when you’ve changed jobs). If you’re paying $30,000 in taxes in April, haven’t you “underpaid” $30,000 in quarterly estimated payments? How does this affect freelancers?
On a related note, is there any decent tax/accounting software that offers help specifically for freelancers? Are normal tax programs — e.g. TaxCut, etc. — geared towards this? Does anything that is geared towards small businesses work just as well for the ups and downs of freelance work?
Inquiring minds want to know!!
Thanks guys – I always wonder what is obvious to people and what isn’t. The whole point of this series was to go through what Peter & I felt are the basics for our team. I was incredibly honored when Cyan decided to pick up the series.
When I started freelancing a year ago, I opened an ING online savings account with a higher interest rate than my regular bank. I throw 30% of every paycheck in there and use it to pay my quarterly taxes. Whatever is left over keeps earning interest.
The interest and the leftovers should cover whatever the IRS asks for in addition to my quarterly checks. (P.s.: I know some freelancers who aren’t even paying the quarterly taxes.)
This actually becomes easier in year two, as your CPA will provide you with estimated tax forms to fill out and send in (with a check, of course). I recommend, however, using EFTPS which is an online method of paying your estimated taxes.
I don’t recommend waiting till April 15th to pay all your taxes, though. You may be penalized. And, it’s easier (at least for me) to pay a little at a time as opposed to a large chunk at once.
When I went freelance, I started two bank accounts, one for by business income and one for taxes. Every time I deposit a paycheck I split it and put the tax money into my tax savings account and never look at it again. It’s so much easier than seeing one lump sum in your business account and subtracting the taxes in your mind.
I think you left out some important info – WHERE to keep the money. Too many people keep money in their bank’s savings account earning 1% interest. I keep my tax money in emigrant direct, a money market account that earns 5% (there are many other online banks with the same rate). This way you’re earning hundreds of free money on your tax savings while you wait to pay it to uncle sam.
Its also not a bad idea to pay your taxes quarterly. That way you don’t have to worry about getting all your ducks in a row once a year and worrying about a huge tax bill when you can break it up into bite size pieces.
@ Design Submit
I agree with that 100%. With an eye on your tax date, putting some money into a short term bond or CD that will mature right in time to pay the tax man is a wonderful idea.
Thats a fantastic point. You should set yourself up so that your tax money works for you.
Make sure you always protect the principle. Never use it to invest in stocks or anything in which you might loose money.
We have a higher earning online savings account (ING Direct) to let it accumulate and put lump amounts (between 15-30k chunks) into higher interest bearing principle protected financial vehicles (like a CD) that matures come April 1st.
Thank you, Shane and Peter! I just set some money aside for next April 15th. Nothing like being prepared in advance. Boy, does that give me some peace of mind!