[Credit: NBC’s Parks and Recreation]
(Rather check out the shortcuts on this? Check it out over here.)
While it’s only natural to focus on the funds coming in to your freelance business, it’s crucial to make sure you also have a system in place for what you’re going to do with your hard-earned money once you get it.
Yes, for all of the time and energy you’ll spend trying to get clients to pay you and doing your personal accounting, you’ll have to put in just as much effort figuring out how you will give that money away in the form of business expenses, your taxes, and — lord willing — some sort of retirement plan.
For starters, you’ll need to plan on having enough money to pay your taxes. If you’re filing individually, you’ll need to take into account your federal income taxes, your state income taxes, and whatever municipal taxes you might owe.
A good way to take a hack at your federal tax burden is to guess how much money you’ll make this year, and then plug that figure into the IRS’ Form 1040-ES. Every state has its own formula for determining state taxes, so you’ll have to check your state taxation department to get a handle on what you’ll owe. Some places — like New York City! — charge municipal taxes that you’ll have to pay, as well.
Keep in mind, you’ll probably have to pay about 15% more of your earnings than what you were paying the last time you had a full-time job. That’s because of the federal government’s self-employment tax, which requires us freelancers to pay extra because we don’t have an employer making making social security and medicare deposits on our behalf. If you’re not into doing all the math required to fill out Form 1040-ES, veteran freelancer Josh Fruhlinger recommends setting aside 25% of everything you earn for federal taxes, plus whatever you’ll need to pay your state and local governments.
Otherwise, if you carve out a few hours one day to make these calculations, you should be good to go. When I did mine, I determined that if I make $65,000 this year, I will need to set aside a total of 34% of everything I make for taxes. Then, I’ll pay one quarter of my estimated tax burden every 3 months for quarterly taxes. You can read about my first time paying quarterly taxes over here.
If you like, you can make your federal quarterly payments online using the Electronic Federal Tax Payment System. Once you sign up, it’ll take about a week for the IRS to mail you a PIN number you’ll need to log in. After you get it, you can link your bank account to the site and pay your federal quarterly taxes directly to the IRS, without having to worry about dropping a check in the mail.
Once it comes time to pay my annual taxes early next year, I’ll collect Form 1099 from all of my clients, which will let me know how much I made from each customer so that I can calculate and pay my yearly taxes. (I also have a running tally, since it’s entirely possibly one of my clients will fail to send me a Form 1099 at the end of the year, but I still need to report the income.)
If you have a business bank account, you can deposit the money you’re designating for taxes there, but I’ve been using a slightly less sophisticated fix. Basically, every time I cash a paycheck, I put 65% in my personal checking account and 35% (just to be safe) into my personal savings account. The money in my savings account, minus the money I had in there when I started freelancing, is what I am keeping ready for the tax man.
Depending on what you do for a living, you’ll also want to keep some money to invest back into your business so that you can maintain and grow your customer base. If you’re an Uber driver, maybe this means money for gas and car repairs. If you’re a consultant, maybe you need a fund for taking clients out to fancy restaurants. If you’re an artist, you’ll need painting materials.
In all cases, the money you’ll have to invest in your business over the coming year represents your current liabilities, which, when subtracted from the money you’ve made from clients, will tell you what your working capital is. This figure is important because it gives you an idea of how much money you’ll have available to keep for yourself or put into expanding your business.
Keeping track of these work expenditures is important because doing so allows you to lower your tax liability by writing them off as deductions. In addition to some of the expenses I discussed a moment ago, you can also limit your taxable income by excluding money you spent donating to charity, purchasing raw materials you needed to create a product, or paying rent to a landlord for office space. If you work from home, you can even take off a portion of the rent you pay each month, so long as you have a room or a part of your home you use exclusively for work.
While you don’t necessarily have to bookmark money for health insurance, you’re doing yourself a great disservice if you don’t. Prices vary based on what state you’re in, but you can find information about signing up for health care under the Affordable Care Act at healthcare.gov. Plus, you will be subject to a federal penalty if you do not have insurance for three or more consecutive months; so, you’ll end up paying something even if you don’t get health insurance.
If after all of this, you still have some money left over that you don’t need to spend on rent, electricity, and the odd order of takeout sushi, you might also consider putting your money into a retirement plan. As middle-aged people in financial services commercials like to say, this allows you to “make your money work for you” when the collection of stocks you’ve invested in — usually a mutual fund of some sort — goes up in value.
I’ve put some of my money into what’s called a Roth Investment Retirement Account (Roth IRA). Whereas a Traditional IRA would allow me to defer my tax payments until I am ready to take the money out for retirement, the Roth IRA requires me to pay taxes on the money now with the stipulation that I won’t have to pay income taxes on it later. I chose a Roth plan because I expect to be making more money at age 60 than I am at 26, so my thinking is that I should pay my taxes on these contributions now while I am in a lower income tax bracket than I will when I am older and (fingers crossed) wealthier.
A drawback of putting your money into either a Traditional or Roth IRA is that you can only contribute $5,500 a year if you are under the age of 50 — $6,500 if you’re older. Meanwhile, an additional downside specific to the Roth IRA is you might not be able to contribute anything if your income minus certain deductible expenses comes out to $131,000 or more.
Generally speaking, if you make a lot of money and are comfortable contributing bigger portions of your income to a retirement account, you might want to try a one-participant 401k, which has higher contribution limits.
And, if you still have money left over after socking some of it away for retirement, well, congratulations, you’ve found a way to pay your taxes, health insurance, and business expenses — all while making a profit and saving money like a responsible adult. You are all about that freelance life, and you are to be commended for your dominance of the self-employment game.
For everyone else, I hope this guide was helpful in moving you further along the path toward financial security nirvana.
*Written by Aaron Taube on behalf of Benny*
Benny's Basics 