There are a few options for calculating your tax obligations and saving the correct amount of money.
As a seasoned financial advisor with a wealth of experience, I have encountered various tax situations and understand the importance of accurate tax planning.
To address this crucial aspect of personal finance, I embarked on extensive research, dedicating countless hours to studying tax regulations, consulting with experts in the field, and analyzing real-life scenarios.
In this comprehensive guide, I will share practical strategies and considerations to help you determine the appropriate amount to set aside for taxes.
Quick Summary
- A general guideline for setting aside money for business taxes is 20-30% of your earnings
- Steps to determine the amount to set aside include calculating your tax obligations, figuring out your net income, and following the 30% rule for saving
- You can use various saving methods, such as the per-payment, and safe harbor method, depending on the consistency and nature of your business income
What to Set Aside for Taxes
One of the most common estimated tax payments rule of thumb is to set aside 20-30% of your earnings.
However, it's important to consult with a qualified tax professional to determine the precise amount based on your specific situation, such as filing status, tax deductions, and applicable tax laws.
Calculating the appropriate amount to set aside for taxes is crucial for financial planning. While individual circumstances vary, it's generally recommended to allocate a percentage of your income toward taxes.
How To Determine the Amount To Set Aside for Taxes
Calculating the appropriate amount to set aside for taxes is crucial for financial planning.
Here are the steps you can follow:
1. Determine Your Tax Obligations
The first step is to determine your tax obligations. This includes federal taxes, state income tax, and local tax.
You can use various resources to figure this out, including the IRS and your state's Department of Revenue websites.
These taxes include:
Self-Employment Tax
Examples of self-employment taxes are Social Security and Medicare taxes that apply to business owners.
The rate is 15.3% of your net income from the business. You can deduct half of this self-employment tax from your income taxes.
Income Tax
Your income taxes are what you pay on your business profits or capital gains [1]. The rates vary depending on your income and filing status. You can use the IRS tax tables to determine how much you owe [2].
Sales Tax
States and local governments impose sales taxes on goods and services [3]. The rate varies depending on the jurisdiction. You'll need to check with your state and local governments to determine the rates and pay estimated taxes.
Franchise Tax
A franchise tax is a tax that some states impose on businesses. The rate and base vary by state. You can find out more from your state's Department of Revenue.
Property Tax
Local governments impose property taxes on the property's value, such as buildings and equipment [4].
The rates vary depending on the jurisdiction. You'll need to check with your state and local governments to find out the rates to pay estimated taxes.
Excise Tax
The federal government imposes excise taxes on certain goods and services [5]. The rate and base vary by type of good or service. You can find out more from the IRS website.
2. Figure Out Your Net Income and Adjusted Gross Income
The next step is to figure out your net income. This is your revenue from the business minus your business expenses. You can use accounting software to track this or do it manually.
You may want to estimate your net income if you're just starting. You can do this by looking at your revenue and expenses for the month and extrapolating that out for the year.
3. Stick To The 30% Rule When It Comes To Taxes
The 30% rule is a general guideline that states that you should set aside 30% of your income for taxes. This includes federal, state, and local taxes.
You can use this rule to help you figure out how much money to save each month. Or, if you're using the safe harbor method, you can use it to determine how much money to save each year.
Excess payments are not calculated in the same way for every organization.
If you want to get more specific or see whether you can save less than 30%, talk to your accountant about how much of your business income should be set aside to pay estimated taxes.
4. Save In A Separate Account
Once you know how much money to set aside for taxes, you'll need to put it in a separate account. This will make tracking easier and ensure you're not spending the money on other things.
You can use your business checking or savings account or open a special account specifically for taxes.
5. Choose a Saving Method
You may have money set aside for taxes as often as you like. However, the ideal savings technique for your business depends on various factors, including the type of business you run and how long it's been operational.
The Per-Payment Method
If you haven't been in business for long or if this is your first year filing an income tax return for your firm, the pre-payment option makes sense.
This is especially true when you operate in a high-risk market, such as healthcare.
Because your business may be growing quickly, it's difficult to predict the current year's total income (and, therefore, taxes owed).
Because the records would be too old, you don't have access to them, and your company's monthly earnings are most likely changing or growing.
Seasonality can make it difficult to predict income for a first-year, especially if your business is affected by it.
Put 30% of each payment a client or customer receives into a business savings account every time.
This is simple to do if your incoming funds are low-frequency but high-value. For example, if clients pay you for project work only a few times monthly, you won't have to worry about setting aside money for taxes too often.
However, if you sell many products through eCommerce, taking 30% off after every purchase is impossible. Calculate your earnings for one week or month and then take the 30% cut.
Consider using one or more payments to cover the current estimated quarterly tax payments if you receive low-frequency/high-value payments and have a robust financial cushion in your bank.
You'll get the joy of crossing that tax payment off your to-do list in one fell swoop, and it will spare you from having to save 30% from each paycheque that comes in.
The per-payment method is only recommended if you're confident that your estimated yearly taxes won't change. If they do, you must account for that by making larger or additional payments.
The Safe Harbor Method
The safe harbor method is a rule that allows business owners to pay a fixed percentage of their taxable income instead of estimated taxes.
This can be helpful if you have difficulty predicting your company's annual income.
You must average your income over the past three years and then pay 90% of that amount. The final 10% is paid in the following year.
This method makes it easier to budget for taxes and prevents you from incurring underpayment penalties.
Unlike the per-payment option, estimated taxes can be paid using the safe harbor method even if your company's income fluctuates yearly.
However, you must have filed federal income tax returns for the past three years to use this method. If you haven't, you must pay taxes using another method.
The Average Method
The average method may be a good option if your business is seasonal or has irregular income.
This technique smooths out fluctuations in earnings by averaging your income over the past three years.
To use this method, add up your taxable income for the past three years and divide by three. This will give you an average annual income.
This method is helpful if you can't use the safe harbor or pre-payment methods because you haven't been in business long enough or your income varies too much.
Like the safe harbor method, taxes using the average method can be paid using any frequency, even if your company's income fluctuates from year to year.
Before using this method, file tax returns for the past three years.
The Monthly Method
If your business has regular income, you can use the monthly method to calculate LLC taxes. This approach is simple and accurate if your earnings are consistent from month to month.
To use this method, multiply your taxable income for the current year by 12. Then, multiply that number by 90% (0.9). The final 10% is paid in the following year.
This method is only recommended if your company's income doesn't fluctuate much from month to month. If it does, you should use another method to calculate taxes.
The Quartly Method
If you receive low-frequency/high-value payments, you can use the quarterly tax payments method to calculate estimated quarterly taxes.
This approach is simple and accurate if your earnings are consistent from quarter to quarter.
The Yearly Method
You can use the yearly method to calculate taxes if your business has regular business income.
This approach is simple and accurate if your earnings are consistent from month to month.
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FAQs
What Happens if You Underestimate Your Taxes Owed?
If you underestimate your taxes owed, you may be penalized for underpayment. To avoid this, be sure to choose a method of calculation that is simple and accurate.
What Happens if You Pay Too Much Taxes?
If you pay too much taxes, you will receive a refund from the IRS. This money can be used to cover future tax bills or other expenses.
How Do I Start an Income Tax Savings Account?
You can start an income tax savings account by setting up a separate account at your bank or credit union. Label the account to know it is for estimated taxes. You can also use this account to set aside money for other self-employment taxes, such as Social Security and Medicare taxes.
When Do I Pay Small Business Taxes?
You will pay small business taxes when you file your annual tax return. Be sure to set aside money each month so that you have enough to cover your income tax bill when it is due.
The Percentage of Income to Set Aside for Business Taxes
Setting aside an appropriate amount for small business taxes is crucial for financial planning.
The exact percentage may vary depending on your business structure, industry, and location.
A general guideline suggests setting aside around 20-30% of your business income for federal, state, and self-employment taxes.
Additionally, consider consulting with a tax professional or using the best QuickBooks accounting software for an LLC to ensure accuracy and compliance with income tax regulations.
Proper tax planning and record-keeping can aid in avoiding unexpected financial burdens and an estimated tax payments penalty.
Regularly review income tax laws and seek professional advice to maintain compliance and optimize your tax strategy.
References:
- https://www.investopedia.com/terms/i/incometax.asp
- https://www.irs.gov/businesses/small-businesses-self-employed/business-taxes
- https://taxfoundation.org/publications/state-and-local-sales-tax-rates/
- https://www.urban.org/policy-centers/cross-center-initiatives/state-and-local-finance-initiative/projects/state-and-local-backgrounders/property-taxes
- https://www.investopedia.com/terms/e/excisetax.asp
