What Percentage of Income Should a Self-Employed Person Set Aside for Taxes?
Discover how to effectively manage your tax obligations as a self-employed individual by understanding key tax types and estimating your tax rate.
For self-employed individuals, managing taxes is a critical aspect of financial planning. Unlike traditional employees, self-employed workers must independently allocate funds for tax obligations, requiring a proactive and informed approach to avoid liabilities.
Major Taxes for Self-Employed Individuals
Navigating taxes as a self-employed individual involves understanding self-employment taxes, federal income taxes, and state and local taxes. Each has distinct requirements and rates, demanding careful planning.
Self-Employment Taxes
Self-employment taxes include both the employer and employee portions of Social Security and Medicare. In 2023, the total rate is 15.3%, with 12.4% allocated to Social Security on the first $160,200 of net income and 2.9% for Medicare. Income above $200,000 for single filers or $250,000 for married couples filing jointly incurs an additional 0.9% Medicare tax. To ease the burden, the IRS permits a deduction for half of this tax when calculating adjusted gross income, which reduces taxable income.
Federal Income Taxes
Federal income taxes are based on net income after deductions, with rates ranging from 10% to 37% in 2023. Self-employed individuals must estimate their annual tax liability and submit quarterly payments using Form 1040-ES. Accurate income and expense forecasting is essential to avoid penalties. Deductions like the Qualified Business Income Deduction, which allows eligible individuals to deduct up to 20% of qualified business income, can significantly reduce the tax owed.
State and Local Taxes
State and local tax obligations depend on residence and business location. Some states have no income tax, while others impose rates exceeding 10%. Local taxes may include city or county income taxes, business taxes, or gross receipts taxes. For instance, California adds a 1% tax on incomes over $1 million to fund mental health services. Consulting a tax professional familiar with state and local laws can help ensure clarity and compliance.
Estimating Your Rate
To determine how much income to set aside for taxes, calculate estimated annual net income by subtracting allowable business expenses from total revenue. This figure informs both federal and state tax liabilities.
Review IRS tax brackets annually, as they may adjust for inflation. Consider the impact of available credits and deductions like the Earned Income Credit or education-related deductions to refine your tax planning.
State and local taxes further complicate calculations. States like Texas and Florida do not have personal income taxes, while others, such as New York or California, impose higher rates. Researching your state’s Department of Revenue website can help clarify applicable rates and available deductions.
Adjusting for Deductions or Credits
Deductions and credits play a significant role in reducing taxable income and the overall tax burden. Deductions lower taxable income, while credits directly reduce the amount owed. For example, the Home Office Deduction allows individuals to deduct business-related home expenses using either a simplified or actual expense method.
Credits, such as the Child and Dependent Care Credit, offer relief for childcare expenses, covering up to 35% of $3,000 in expenses for one dependent or $6,000 for two or more. Additionally, energy-efficient home improvements may qualify for the Energy Efficient Home Improvement Credit.
Reassessing Your Percentage Over Time
Regularly reviewing the percentage of income set aside for taxes is essential to avoid unexpected liabilities. Fluctuating income levels, changing expenses, and updates in tax legislation can all impact tax obligations. Examining financial statements and cash flow projections can help identify necessary adjustments.
Staying informed about legislative changes is crucial, as new policies may affect deductions, credits, or tax rates. Working with a tax professional or using reliable tax software can help ensure compliance and optimize your tax strategy.