Managing Taxes as a Freelancer and Sole Proprietor
One thing I didn’t have when I started my business was experience in actually running a business, managing my cash flow, and preparing for taxes. Income taxes are something everyone has to pay, but when you have your own freelance business, it is even more important and complicated to prepare for your taxes.
It is a common misconception that once you start a business, you can do your accounting so that you don’t have to pay taxes. You always seem to hear people saying I don’t pay any taxes, I own a business, but they’re simply misunderstanding their own taxes.
Sole Proprietors Pay Taxes Once Per Year
As a self-employed sole proprietor, you don’t pay taxes every two weeks, when you get paid like in a regular job. You are paid when you receive cheques from your clients and when you do get paid, you don’t have any income taxes or employment insurance deducted as you would when you get a pay cheque from work. You pay your taxes once a year when personal income taxes are due. Regular employees pay taxes every time they get paid from their work. I once said to someone I had to pay over $10,000 for taxes this year when I submitted my tax return. That person looked at me like I was being royally screwed by the government or if I was doing my bookkeeping totally wrong. The problem was that that person didn’t make the connection that every pay cheque they have income tax and employment insurance deducted and sent into the government. When they do their tax return they are really calculating how much tax they should have paid over the course of the year and subtract how much they’ve already paid from their pay cheques. Sometimes they have to pay to balance out their taxes and sometimes they get a refund.
The difference with a self-employed sole proprietor is that we don’t pay taxes throughout the year, and when personal taxes are due we must calculate how much we owe and pay then. So if a regular employee pays $20,000 in income taxes throughout the year in deductions from their pay cheques, and in doing their tax return find that they should have paid $20,500 then they owe $500 to the government, if they should have paid $19,000 they get a $1000 refund. If you are a freelancer you pay $0 throughout the year, and when you calculate what you owe you will always owe something and if you make decent money, it should be a fair amount of money, usually in the 5 digits.
How To Save and Prepare for Your Income Taxes
The single biggest tip I can think of is to set up a separate bank account and everytime you get paid by a client, deposit 30% of that cheque into that separate bank account. This account should be a high-interest savings account, or what I did was set up an investment account and invested the money in very low-risk stocks and mutual funds — in this case you will at least generate some interest income on the money over the course of the year while you save it for taxes.
Why 30%? It’s just an even number I picked. Based on your annual income you may want to adjust that percentage, but you want to account for any sales taxes you have to charge clients as well, and you also want to make sure you put away a little more as opposed to a little less money. It’s pretty nice when tax time comes around and you have $13,000 in your investment account and only have to pay $10-$12,000 - it’s a nice little bonus as opposed to having to pay an additional $1-2,000. An article I read by Doug Bowman at Stop Design talks about saving for taxes and advises against using an investment account, and I totally agree that you should stay away from “high-risk stocks” like he mentions, and just stick with the standard account interest or some pretty solid, low-risk stocks that will generate even a 5% return in a year. That’s better than you’d get form any bank I know of.
There’s another great article at Freelance Switch as part of their Business of Freelancing series, with some more advice on saving for taxes.
Is This Better?
In some cases it’s nice to manage and pay your taxes this way, because if you do have $20,000 or $30,000 in that account you can get some pretty sweet interest over the course of the year, and at least you have it in case of an extreme emergency and you need to dip into it a little. Would I prefer to handle my taxes this way rather than having it deducted from a pay cheque? I’m not sure, the pros to this method is that you are in charge of your money, and you have a nicer cash flow. You can spend all the extra money you earn in the first 6 months of the year and save a little more than the 30% in the last 6 months if you need to so you can manage your cash flow that way which is kind of nice. However, the only con is that you have to be organized. It’s easy to get carried away with the amount of money you have in that account and find out you have to come up with $5,000, $10,000 or more when you have to pay your taxes.
