Why the "30% for Taxes" Rule Doesn't Always Work for Businesses
When you start a new business or side gig, you might hear the advice: "Set aside 30% for taxes." While this might sound like sound advice, it's actually quite lazy. It's not "bad" advice, per se, but it's certainly not the most efficient or accurate approach.
When embarking on a new side hustle, it's crucial to understand the two main types of taxes you'll encounter:
- Self-Employment Tax
- Income Tax
Understanding Self-Employment Tax
Self-employment tax is a flat 15.3% of 92.5% of your net business income. Therefore, you should set aside 15.3% of your net business income to cover this tax.
Determining Income Tax
Income tax is a bit more complex and varies based on several factors. You pay income tax on your net business income, but various deductions and adjustments can significantly lower your taxable income. Examples of these deductions and adjustments include:
- Standard Deduction or Itemized Deduction: These reduce your taxable income by a set amount.
- HSA Contributions: Contributions to a Health Savings Account can be deducted from your taxable income.
- Self-Employed Health Insurance Deduction: You can deduct premiums paid for health and dental insurance if you are self-employed.
- 50% of Self-Employment Tax Deduction: You can deduct half of your self-employment tax from your taxable income.
In addition to deductions, tax credits, such as the Child Tax Credit, can further reduce your overall tax liability.
Why Setting Aside 30% Might Not Make Sense
In the early stages of your business, it’s not uncommon to pay little to no income tax due to these deductions and credits. There are instances where new businesses end up owing $0 in income tax in the early years of the business. In such cases, setting aside 30% of your income for taxes would be unnecessarily overcautious.
The Importance of Proactive Planning
Rather than following a blanket rule, it's crucial to work with a financial planner or tax professional (like a CPA or EA). These experts can help you:
- Track Your Income and Expenses: Keep detailed records of your net income throughout the year.
- Estimate Your Taxes: Calculate your tax liability based on your actual net income and applicable deductions/credits.
- Avoid Overpaying or Underpaying: Aim to pay an amount close to your actual tax liability to keep more revenue available for reinvestment in your business.
Conclusion
Starting a new business requires smart, proactive financial management. Blanket advice like "set aside 30% for taxes" can lead to inefficient use of your funds. Instead, work closely with a tax professional to accurately estimate your tax liability and optimize your financial strategy. This will help ensure you keep as much of your business revenue available throughout the year for growth and reinvestment, rather than earmarking too much for taxes unnecessarily.
If you're starting a side business and need guidance on managing your taxes effectively, feel free to reach out to a financial planner or tax professional. They can help you navigate the complexities of self-employment and income taxes, ensuring you make the most of your hard-earned money.