It can be daunting to start your own business and figure out the tax situation as you go. You get all the benefits of working for yourself, like setting your schedule and choosing your own clients, but you also get all the responsibility of creating a smart tax and retirement savings plan for your newfound income.
One of the great boons of self-employment, however, is that you can do your research and pave your own way to success.
Here are some great ideas for how to make your first tax year as a self-employed worker as painless as possible:
Begin Saving for Quarterly Taxes Right Away
Whereas your day job employer automatically deducted taxes from your paycheck, you will now be your own boss in more ways than one. You have to deduct all taxes yourself.
The first thing to find online are the relevant estimated tax forms: these are 4 simple slips of paper that allow you to pay your taxes in 4 easy payments throughout the year. How much should you save for these payments? Everyone's specific situation is different, but many self-employed workers save between 25 and 30% of their income for these taxes. They are paid once a quarter, on or near April 15, June 15, September 15, and January 15.
All of this information is important, but there is another reason to do this immediately: the sooner you start saving for your estimated taxes, even if they aren't due now, the easier it will be to get used to your actual take-home pay. Many self-employed rookies think they are making far more money than they really are, because they receive their entire gross pay, instead of only getting the net after taxes.
Start the habit early where you make all necessary deductions before you see your money as truly 'yours to spend.' This can pinch in the moment, but it makes life so much better come tax time!
Don't Forget Social Security
Social Security and Medicare are taxes that are separate from your typical income tax. When you are employed by someone else, half of your employment taxes (Social Security and Medicare) are paid by your employer, with the other half passed on to you.
As a self-employed individual, you'll most likely be responsible for that "other half" now, which hovers around 8% of your income at this point in time. Yes, that seems like a lot, but believe me, having social security when you retire is worthwhile! Make sure that you are factoring in this 8% deduction from your gross income when you set your income goals since we don't often think about that amount.
Learn About Expense Deductions
While all of these tax conversations may seem like a frustration, one of the big perks of being a self-employed worker is that you get to deduct many of the expenses of doing business! For example, if you need a new computer, which will be used entirely for business, you can deduct the cost of that equipment. You can also deduct portions of your rent or mortgage if you have a home office dedicated to work, or if you rent office space for your self-employed business.
There are specific regulations for each available expense deduction, but it is always worthwhile to keep track of things like the mileage you put on your car. With mileage, your detailed notes help you to justify deducting a certain amount of miles put on your personal vehicle at a standard rate. For every $1 of expenses you have, you offset $1 of taxable income, meaning a reduction in your total tax burden. Working with an accountant who specializes in self-employment income can help you strategize.
Start an IRA to Save For Retirement
As a self-employed person, the options available to you may be very different than they were at a typical employer. Rather than a 401(K) or 403(B), you may prefer to open an IRA or Roth IRA (Individual Retirement Account). These accounts have yearly limits on how much you can deposit, but they don't require you to have an employer sponsor.
Self-employed individuals can also qualify for a range of other retirement products (including a special "self-employed 401(K)" if you wish), but an IRA is an excellent and simple vehicle if you want to get started. Regardless of how you choose to save for retirement, as soon as you are making your monthly target income goals, it is wise to start automatically contributing to these accounts. It's smart to go ahead and save as early as you possibly can, so you don't even miss that money.
Talk to An Accountant About Business Structures
Many self-employed workers (most of them, in fact) are sole proprietorships, but it is also possible to create partnerships, LLCs, S-Corporations, and C-Corporations when you start a business. Each of these structures carries different advantages and disadvantages, and reading about them is a great idea.
However, your best choice for one of these structures is going to depend heavily on your individual circumstances, so the best plan is to go see an accountant who specializes in self-employment. Give him or her a complete picture of your financial situation and goals, and they can offer suggestions on how to structure your business in a legal way that minimizes your tax liability.
Still have questions about being self-employed? Check out our previous posts on becoming an entrepreneur as a travel agent and how to align your goals with good business practices.