A couple years ago I had my first sizable “side income” from blogging and freelance work.
Unfortunately I also made an embarrassing, yet common, mistake: I didn’t plan for taxes appropriately.
Needless to say I ended up owing the IRS a decent chunk of change come tax time. Ever since then I have been vigilant about making sure that I take the appropriate steps throughout the year so that I’m prepared when tax time comes around.
Today I want to talk about how to plan for taxes for side income. Specifically I have three suggestions for how you can plan your taxes for side income better and not end up owing the IRS a large amount come tax time.
1) Pay Quarterly Estimated Taxes
Quarterly estimated taxes can be incredibly confusing to anyone who is new to making side or freelance income.
As most people know, when someone works for a business they have taxes withheld from their paycheck. These taxes cover a number of different taxes, but the most important is income taxes. If an employer did not withhold taxes for their employees, employees would have to pay in a relatively large lump sum at tax time. Instead, many employees even get money back from the government.
For freelancers and small business owners, the responsibility falls entirely on their shoulders. Quarterly estimated taxes are supposed to reduce the tax burden freelancer/contract workers feel when tax time comes around.
I wrote a post about how to calculate quarterly estimated taxes that includes a spreadsheet tool that will help you determine how much to pay in. The post also explains when quarterly estimated taxes are due as well as where to send them.
2) Take Additional Taxes out of your Paychecks
While full-time freelancers are not employed at a 9-5 job, those who make side income by definition are employees for their full-time gig.
One strategy that you can use to account for taxes on side income is to take additional taxes out of your paycheck. You may not know this, but employees can voluntarily have $50, $100, or any other additional amount taken out of their paycheck and put towards tax withholdings.
This is a strategy that I’ve been using the past few years to add some “padding” into my tax withholdings. Quarterly estimated taxes are great, but they are in essence simply an estimate and can easily end up being low if your side income increases year-over-year.
3) Build up Cash Savings in your Business Account
Besides paying quarterly estimated taxes and voluntarily having additional money taken out of your paycheck for taxes, you can also plan for taxes for side income by building up cash savings in your business account.
You have to pay taxes one way or another, so having additional money in your business account (or personal account if you do not have a business banking account) can help you prepare for any unexpected taxes.
I personally start to hoard cash in my business account around the December through February time frame. Building up cash in my account around this time will not only help me pay any money I owe to the government but will also provide me funds for my first quarterly estimated tax payment of the year (which is due mid-April).
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I hope that this post on how to plan for taxes for side income will help you be better prepared for taxes in the future. Taking these three steps will help you adequately plan for your side income taxes, as well as have money set aside in case of a tax-time surprise.
Have you ever planned poorly for taxes and owed a lot of money to the IRS? How do you plan for taxes for side income?
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This will be my first year filing quarterly. I’ve been deducting each month into a designated “tax” account.
Good tips DC! We just finished our taxes last night and will be taking them in to our CPA later today. I remember making out our first quarterly check a number of years ago and hating having to send that money in – it’s almost as you feel it more. But, now, I just try and view it as a good problem. :) We pull out 30% off the top of everything we have come in and throw it in an account designated for taxes, that way once the quarter is up we transfer out the money and write the checks.
This is the no fun part of self employment/ side hustling. I think it’s helpful to take 30% of monthly earnings and set them aside. Just consider them gone, and it will be less painful once tax time comes.
brokeandbeau Good for you for setting money aside. The quarterly tax payments are a big drain on my side income, but it’s tough when you know you will be paying in over 40% of your income into taxes.
FrugalRules Yeah the quarterly taxes sting more than paycheck deductions. Many people think that if you had to pay in one big check each year for your taxes that that the tax code would change overnight. I can’t help but agree with them!
TheWriteBudget Unfortunately the actual taxes (at least in Minnesota) is above 40%. If you have 100% freelance/self-employed/small business income you really need to be careful if you don’t want to pay in a big chunk come tax time.
I’ve done quarterly payments for years and I hate every single one, but like John said, it’s a good problem to have. Once you get onto the mindset that what you get paid isn’t what you get to keep, it becomes second nature to put a chunk aside. I’d rather hold it than give an early gift to Uncle Sam.
I definitely planned poorly for taxes in the past, but kind of like you, it just takes one painful lesson to learn really quickly. We are definitely on top of our game now, but despite knowing I am better prepared, it still doesn’t make me less concerned every year when we go to file. Our painful time still haunts me no matter how much time has passed.
The first year I was an S-corp, I wasn’t organized enough to deal with quarterlies. Luckily, in the first year you can usually get away with “I didn’t pay myself to maximize profits.” The second year, I was very frustrated because the CPA I used hadn’t thought to tell me you have to file 941 forms, not just including them in general taxes.
An IRS agent gave me a suggestion that kept me from paying interest (say you pay yourself yearly), but otherwise I would have owed big time. Very annoying.
Eyesonthedollar I think the first year paying quarterly taxes is the toughest because you aren’t used to so much going out the window, especially not the relatively large checks you have to write four times a year. Once you are used to it, though, it becomes a bit easier to plan ahead. I think quarterly taxes are a good thing, though, because people realize just how much the government takes out of each dollar you make.
blonde_finance Same here. Even if we get money back this year, I will still be paranoid about next year’s taxes. I almost feel like I can’t put enough in quarterly taxes or have enough taken out of my paycheck. I don’t want to deal with owing the government a relatively large amount of money.
AbigailP I’m surprised an IRS agent gave you that advice! It makes sense, though, and seems like a plausible argument for not paying quarterly taxes.
I always do additional withholding from my employer. At some points of the year, generally 4th quarter, it is over $4K a month in extra taxes, on top of claiming single withholding 0 deductions.
Taxes are a part of life. I am getting to the point of not having to pay as much, and drawing from the system instead of paying. Hopefully, all you younger folks keep paying…;-)
No Nonsense Landlord Wow $4k/month is quite a bit, but with all your rental income it makes sense. I personally do not anticipate social security to still exist when I retire. I’ve had people tell me otherwise but at the very least it won’t be around in it’s current unsustainable form. I do think we need to honor the commitments we’ve made to those who are nearing retirement. I just wish they had an option to opt out for people my age.
Great post DC!
Any more information or resources on #2? I usually find myself putting the money from my freelancing aside on my own, but it would be incredibly helpful to be able to have it automatically deducted.
Ultimately, I absolutely love this time of year, because I get to nerd out on my taxes!
Brandi_P Thanks Brandi! I do not have any additional resources for #2. If you have an estimate of what your taxes will be from freelancing, though, you can have that amount deducted over time from your paycheck. You have to go into your employer’s system or have the administrator manually set up the additional withdrawals, but it’s pretty easy and I’m personally really happy that I did it last year.
By the way, do you have a blog? I didn’t see one listed in your LiveFyre profile.
DC @ Young Adult Money No problem! Thank you for the advise! I feel like doing that would take a lot of stress off of trying to do it on my own.
I don’t currently have a blog, although I have one in the works which will hopefully be up soon!
Thanks, DC!
Brandi_P DC @ Young Adult Money Hey be sure to let me know when you start your blog!