One of the biggest adjustments people face when they become self-employed has nothing to do with finding clients or marketing their business.
It’s taxes.
When you’re an employee, taxes happen quietly in the background. Your employer withholds federal and state income taxes, Social Security, and Medicare from every paycheck. You simply receive what’s left.
Once you become self-employed, that tax responsibility shifts to you.
It’s one of the most common initial conversations I have with a newly successful soloprenuer or business owner. They’ve finally made money, and now they owe a bunch to Uncle Sam!
This can catch someone off guard, if they spent as if it’s already theirs. That’s why you should build a process for estimating and setting aside taxes throughout the year.
Start with Profit, Not Revenue
The first mistake many new business owners make is estimating taxes based on total revenue.
Revenue tells you how much money your business brought in. Taxes, however, are generally based on your profit, or the amount left after legitimate business expenses have been deducted.
For example, if your business generates $150,000 in revenue but has $40,000 in business expenses, you’re generally estimating taxes on the remaining $110,000, not the full $150,000.
That makes keeping your bookkeeping current incredibly important. If your expenses aren’t accurate, neither are your tax estimates. Also, if you’re estimating based on revenue, you’re also almost certainly overestimating the success of your business.
Creating a profit and loss statement gives you the best starting point for understanding your tax liability.
Don’t Forget Self-Employment Tax
One surprise for many first-time business owners is the self-employment tax.
As an employee, you pay half of your Social Security and Medicare taxes while your employer pays the other half. Once in self-employment, you become responsible for both portions of Social Security and Medicare.
Combined, that’s 15.3% for Social Security and Medicare taxes, subject to the applicable wage limits and Medicare rules.
This doesn’t replace your federal or state income taxes, but it’s an addition to them.
Understanding that self-employment tax exists helps explain why your tax bill may be much larger than it was when you worked for someone else.
Set Aside Money Throughout the Year
One of the simplest habits you can build is creating a dedicated tax savings account.
Each time you receive payment from a client, immediately transfer a portion into that account.
By treating taxes like any other business expense, you’re less likely to spend money you owe the IRS or your state.
The exact percentage varies depending on your income, deductions, state taxes, and business structure. Many start with 33%, which can be a good back of the napkin amount. Although, the moment you begin seeing significant increases in income, you’ll want to do a better job of estimating. That way, you’re not overfunding or underfunding your own needs.
Eventually, the goal isn’t to guess perfectly but instead consistently build the habit of setting money aside as you earn income.
Review Your Numbers Quarterly
Your business is constantly changing.
Revenue increases. Expenses fluctuate. You may add clients, raise your rates, or experience slower periods than expected.
That’s why estimating taxes shouldn’t be a once-a-year exercise.
Every quarter, review your profit and loss statement and compare your actual profit to what you expected at the beginning of the year.
If business is stronger than anticipated, you may need to increase your estimated tax payments or the amount you’re setting aside.
If revenue slows, you may be able to adjust those estimates downward.
Regular reviews help eliminate surprises and keep your tax plan aligned with what’s actually happening in your business.
Pay Taxes Throughout the Year
You may know about estimated taxes, but you also may hold off for fear that the business will struggle in the future. It’s better to go ahead and pay the amount, remove it from your balance sheet, and move on in growing the business.
IRS expects this, but also if you don’t, other parts of life can arise, leaving you quick to raid that tax savings account. By removing the urge, you’re not leaning on it as a backstop.
It also has the added benefit of ensuring you’re not having to pay late payment penalties or anything of that nature.
Even if your estimate isn’t perfect, making thoughtful quarterly payments is often far better than ignoring the issue until your tax return is prepared. Then, as the business grows, it’s important to lean on guidance to tighten those estimates moving forward.
