How Much Do I Budget for Taxes as a Freelancer?
By Paula Pant. Budgeting & Personal Finance Expert
Paula Pant is an award-winning personal finance journalist. She runs the popular personal finance site Afford Anything and she frequently writes, speaks and makes media appearances to discuss money management for ordinary American families.
“Help! I’m self-employed / I’m a freelancer / I’m a small business owner. And I need to budget for my tax bill. But I don’t know how to do it!
“How much should I set aside for taxes? Especially if I don’t know how much I’ll end up earning within the next few months? I might make $40,000 this year, or I might make $240,000. How can I budget for my estimated taxes ?”
This is a common budgeting question that I hear self-employed people asking.
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There are a few ways to do it --
#1: Set aside 25 to 30 percent of every paycheck that comes in. This feels awful when you're also trying to pay off debt. But quarterly payments are due, well, roughly every 3 months, so this is money is a "short-term" (immediate) expense. You have to pay for groceries and heat, even when you’re paying down debt. Similarly, you have to pay taxes.
This is also, logistically, the easiest choice. You don’t have to guess at how much you’ll earn through the next few months.
You only take an amount that’s proportional to that particular paycheck.
The easiest way to execute this is to set up a savings account earmarked for taxes. and link that savings account to the checking account in which you deposit your business/freelance income. Then automatically withdraw that money. Online banks like SmartyPig can help you do this.
If your bank won’t allow auto-withdrawals by percentage, then you’ll have to manually shift the money into the savings account. Do this the moment you deposit the check, so that you won’t forget.
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#2: Here’s an alternate tactic: Calculate how much money you earned in the past month,
and set 25 to 30 percent of your monthly income aside.
This tactic assumes you’re already saving a pretty big proportion of your income, which would be just sitting in your account. If you’re not already in that position, or if you think you’d find it too tempting or easy to spend down that money, then avoid this pointer. Only do it if you tend to have ample extra money in your account each month.
#3: Estimate how much you think you'll earn this upcoming year. Calculate 25 to 30 percent of that. Divide by 4. That's the amount you need to set aside each quarter. If you estimate you'll make $100K in gross income, for instance, and you decide to set aside $28,000 of that money, you need to save $7,000 per quarter.*
- (Note: estimated tax payment deadlines aren't exactly on the quarter schedule. They're in April, June, Sept and January).
Personally, I take option #3, because I like getting a huge paycheck and setting the whole thing aside for this quarter's taxes. In one fell swoop, I know that I'm done.
But that’s how I budget -- I devote entire paychecks to just one goal. Paycheck A is for this quarter’s taxes. Paycheck B is for my health insurance premiums for the entire year. It will get deposited into an account that my health premiums are withdrawn from.
Paycheck C will max out my IRA contribution this year. Paycheck D is “everyday” money: gasoline, groceries, restaurants. Paycheck E will cover my electricity and gas for the whole year. This is like Dave Ramsey’s “snowball” plan, but applied to savings and budgeting rather than applied to paying off debt.
But to choose this option, you need to have plenty of wiggle room in your finances, and a large cash cushion. Most people prefer option #1, which allows a more save-as-you-go plan. It demands a little more management, a little more of a hands-on approach. But it works with the realities of your day-to-day budget.Source: budgeting.about.com