Free Masterclass: Tame the Tax Monster. April 28 @ 11am PT/2:00 pm ET. Sign up now!
Learn the biggest mistakes to avoid when you're starting out fresh as a freelancer or independent consultant
Starting a new business as a freelancer or soloiprenuer after you've worked a 9-5 puts you in completely unfamiliar territory. Though you know the ins and outs of serving your clients or customers, you may be less familiar with the financial, behind-the-scenes side of things. It's not unusual when covering new ground to make a mistake every now and then, and some of the biggest financial mistakes you can make as a new small business owner involve taxes.
When you work as a W-2 employee, your employer will handle most or all of your withholding for you. Once you break out on your own, you’re responsible for setting aside enough money to pay your taxes throughout the year at a rate that’s acceptable to the IRS to avoid penalties.
With every payment that comes in, you should be putting aside money for self-employment taxes and income tax. The rate for self-employment taxes is 15.3%, and the amount you'll need to allocate to income tax will vary based on your state. In general, expect to set aside about 30-40 percent of what you're making for quarterly taxes. You can get a personal estimate with this estimated tax calculator.
Putting aside money regularly will also help you pay your quarterly taxes, something you will be required to do if you expect to owe $1,000 or more in taxes through the year. In most states, you are expected to pay 25% of what you anticipate owing in taxes every quarter to avoid penalty, or, at a minimum, 100-110% of what you paid last year in taxes. Your quarterly taxes include self-employment and income taxes paid on the federal and state level.
An all-too-common organizational mistake is not having separate bank accounts for personal and business transactions. Sometimes, just having this record is enough, even without bookkeeping software, to have the documentation you need for taxes.
The amount you'll owe in taxes will also be dependent on your deductions. Keeping good records is key to making sure you're deducting expenses and reaping the tax benefits of staying organized. Home office and mileage deductions, for example, are two that often get overlooked.
It’s easy to get wrapped up in reinvesting in your business. When you’re just starting out, investing in ways that grow your business is a good idea. You’ve got to start somewhere, and paying back into the business can help you build better processes and land bigger work. However, if you haven’t built up the habit of paying yourself, you’re paying yourself randomly, or you’re chronically underpaying to the point that you’re always stressed out about day-to-day expenses, you need to build the habit of paying yourself first.
Think about paying yourself as setting a value on your own time, as well as setting the foundation for what a sustainable business looks like for you in the long-run. By doing this, the decisions you make about your business end up being better. You’re thinking about paying yourself first and then investing with what’s left over, leaving you with less to play with and a need to be more decisive and strategic with the funds. It’s fine to start out small if you don’t need the cash, but don’t make that your practice forever.
Another important part of paying yourself first is investing in your retirement and any other funds tied to your life and financial goals - an emergency fund, further education, trips, or your dream home, for example. At a minimum, make sure you are setting aside retirement funds pre-tax and invest in a SEP-IRA. Capture that deduction now and it’ll make you that much happier come tax time.
When your business hits a certain level, your accountant may start suggesting you switch from a sole proprietorship or an LLC to an S Corp. This is sold as the "sexy option" and is also normally suggested with the assumption that you will hit and maintain six figures in the years to come.
However, we would encourage you to not take this decision lightly, especially if you've had fluctuations in your business, you've just started hitting six figures, or you're not sure what your growth trajectory looks like yet. It's not uncommon for the administrative costs involved in managing an S Corp to outweigh the tax benefits of making the switch, that is, until you reach and stay at the $150-200k range.
Before jumping into an S Corp with both feet, make sure that you are continuing to hit consistent numbers for a few years and feel like you are solidly in the 6-figure range. What you don't want is for your administrative costs to be eating some of your revenue without any tax benefit to make it worth your time.
We’re here to help you avoid small business tax mistakes. That’s why we created Ruby Money - to make it easier than ever to save for taxes and retirement with the click of a few buttons. If you’re ready to set your savings on easy mode, reach out for a demo!