By Bryan Lee, CFP®, MBA
When your monthly income is not consistent, whether due to freelancing, contract work, or owning your own business, understanding tax planning strategies can feel like putting together a jigsaw puzzle. Let’s consider these 5 tips to help you handle your tax payments effectively when your monthly income varies.
1. Understand When Estimated Tax Payments Are Due
Self-employed individuals, entrepreneurs, real estate brokers, and other non-W-2 workers are responsible for paying taxes directly to the IRS in the form of quarterly estimated payments. Being your own boss means you have to calculate and remit payment for what you owe; it’s not automatically deducted from your paycheck like it is for W-2 employees.
This is great in that you don’t have to pay taxes right away, but it can quickly become an administrative and financial burden if you don’t stay on top of it.
To better manage your tax payments, you must first understand when they are due. This table highlights the typical due dates for quarterly estimated tax payments:
Failure to pay your estimated taxes or paying them later than each due date may result in hefty penalties and interest charged by the IRS, so it’s critical to stay on top of these dates. 2. Understand How Much You Should Pay
If you have other income that is subject to withholding (wages for yourself or a spouse, IRA distributions, pension payments, Social Security, etc.), you could have more withholding from those sources in order to reduce your need to make estimated tax payments. However, depending on the ratio of your business income compared to these other sources, you may still need to make quarterly estimated tax payments.
Understanding how much you should pay in taxes can be especially difficult if your income fluctuates each year. If you overpay, you run the risk of giving the IRS an interest-free loan, and if you underpay, you run the risk of paying penalties and interest. In this case, the safest thing to do is to avoid the underpayment penalty by paying the lesser of the following:
- 90% of your current year tax liability or
- 100% of your prior year tax liability (or, if your adjusted gross income for the prior year was more than $150,000, then you must pay 110% of your prior tax liability)
Keep in mind that the IRS also provides a stipulation if you receive uneven income throughout the year. You may be able to reduce or avoid penalties by annualizing your income and making unequal payments throughout the year based on the income from each of the time periods above.
This is also the reason why it is important to separate your business and personal expenses so you can accurately track your net income from the business. If you don’t have an accounting system (such as QuickBooks), then running reports showing the net income for each of those time periods is harder to track. Spending a little time to stay organized during the year can help you calculate how much you should be paying in estimated taxes to avoid underpayment penalties and interest charged by the IRS.
3. Create a Tax Plan
After you determine how much tax you should pay, the next step is to create a tax plan to ensure that you save the appropriate amount. The general rule of thumb is for self-employed individuals to set aside 25-40% of their income for taxes, but the exact amount you need to set aside depends on your business structure, tax bracket, state of residency, and more.
If your income is relatively consistent, you can apply a formula for each dollar that you receive (i.e. 50% left in the business for operating expenses, 30% saved in a separate bank account until you need to make estimated tax payments, and 20% to be distributed for personal expenses). Depending on the structure of the business, total income, and other factors from your business, these ratios may need to be adjusted. However, it is a good starting place to limit any potential surprises when it comes time to file your taxes next April.
For individuals with irregular income, it’s important to adjust your savings as your income fluctuates. If you have a particularly successful month, consider putting 50-60% away to make up for months where your income is lower. Working with a wealth manager and/or utilizing a bookkeeping system are great ways to stay on top of your tax payments so you don’t find yourself facing a penalty come tax season.
4. Keep Track of Deductions
It’s easy to forget about all the expenses you paid for when you’re focused on managing your irregular income. But it’s important to document as much as you can in order to take advantage of every applicable deduction. This may help you reduce your tax liability, ultimately reducing your estimated tax payments and putting less strain on your uneven cash flow.
There are dozens of expenses you can deduct as an entrepreneur or real estate broker. Here are a few of the most common deductions:
- Startup costs
- Online services and subscriptions
- Travel expenses and a portion of business meals
- Continuing education
- Software, hardware, and other equipment
- Health insurance premiums and medical care expenses (depending on your business structure)
- Home office expenses (mortgage interest, property taxes, utilities, etc.)
- Supplies, repairs, and maintenance
- Retirement contributions
5. Partner With a Professional
When your monthly income varies, proactive tax management can be your financial compass. From estimated tax payments to careful tax planning, sometimes it helps to garner a second opinion. Taxes are a part of life, but with careful planning (and the help of a seasoned professional), they need not be a source of stress.
Our Strategic Financial Planning team would love the opportunity to enhance your tax strategy. Call (972) 403-1234 or contact us online to set up a complimentary get-acquainted meeting so we can see if we are a good fit!
Bryan Lee is the founder and president of Strategic Financial Planning, Inc., an independent, fee-only financial advisory firm. With more than 27 years of industry experience, Bryan uses a unique client-first financial life planning approach and process to help his clients get the most out of life. Bryan earned his Bachelor of Business Administration in finance and his MBA in international finance from the University of North Texas. He is also a CERTIFIED FINANCIAL PLANNER™ professional.
Bryan is actively involved in his community and industry and has served on the boards of several associations and charities, including the Dallas/Fort Worth chapter of the Financial Planning Association, the National Association of Personal Financial Advisors, Family Services of Plano, the CITY House, and the Journal of Financial Planning. Bryan has been featured in local and national media, including The Wall Street Journal, Investors Business Daily, CNNfn, USA Today, SmartMoney, Kiplinger’s Personal Finance, Financial Planning Magazine, The Dallas Morning News, and Dow Jones Newswires. And, he has been recognized as a Five Star Wealth Manager and one of Dallas’s Best Financial Planners in D Magazine every year since its inception and recently as a Top Wealth Manager. To learn more about Bryan, connect with him on LinkedIn.