Freelance taxes are a complex topic and often the bane of any contractor’s financial plan. Recently, I learned that even with the best-laid plans and professional advising, a big spike (or drop) in income can throw you for a tax loop.
Last year, due to a mix of good fortune and good marketing, my income rose and it put me into another tax bracket. Fortunately, my accountant was able to spot the coming hurdle, and I had enough warning to spread out my savings across a few months to meet the increased tax bill. However, my social media feeds and writers’ groups were filled with horror stories of writers who didn’t see it coming and got hit with a large tax bill that depleted their savings — or worse, put them on a payment plan with Uncle Sam.
Here’s a closer look at how variable income affects taxes and strategies freelancers can use to plan ahead.
Yearly Planning: Your Starting Point for Taxes
Each year, I start my tax planning with a sit-down with my accountant. We look back at the past year and evaluate my book of business — as well as opportunities in the pipeline or changes I suspect are coming — to project what my income will be. From there, it’s easy to predict what quarterly and annual tax payments.
However, it’s just a starting point. Any number of factors can impact your taxes throughout the year, such as:
- New contracts. Taking on a new contract or adding accounts with an existing agency can lead to a five-figure spike in income that drastically changes your tax commitments.
- Losing clients. If a client moves on from an agency and you don’t replace that income — to make more time to work on a personal project or spend with your family, for example — that can lead to lower overall revenue and taxes.
- Increased expenses. Last year, I added two team members to my business. One is a copy editor on retainer, and the other is a virtual assistant whom I pay hourly. These expenses have been critical to growing my business, but have also reduced profits and, consequently, my taxes.
Monthly Expense and Income Tally
As a freelancer, it’s critical to keep track of your expenses. Month over month, these can impact your margins, revenue and the amount of taxes you will have to pay. There are certain expenses you can project on a monthly or annual basis. For example, if you deduct a home office or pay for business insurance, these are fixed costs. When projecting your taxes, it’s easy to forecast your deductions for them.
Unfortunately, freelance taxes aren’t just disrupted by big fluctuations in cash flow. They can also be impacted by changes in expenses. For example, needing to replace an expensive computer could lower your tax obligation. Once another freelancer decided to work from home since her kids were in school, the loss of deductions for an office, utilities and other services dramatically increased her tax payments. Be attuned to shifts in your expenses, and think through how they’ll impact your tax obligations.
The other component of your monthly big picture is tracking your income. Determine how much you made and whether that’s on track with what you planned, or if it’s above or below what you expected. Making those judgments on a regular basis will ensure you’re staying on track with your necessary payments.
How to Prevent Being Waylaid by Surprise Tax Bills
- Commit to a monthly financial review. Stay on top of your finances. It’s easy to get busy and let things go, but this is when you can get hit with surprises. End each month with a clear understanding of where your revenue and expenses have gone — and where they’ll be going.
- Pay your taxes monthly. Even though you’re only obligated to pay taxes quarterly, make sure you’re setting aside the amount you’ll need to pay on a monthly basis. Some people use the strategy of immediately transferring a set percentage of every payment they receive into a dedicated tax account.
- Keep a dialogue going with your accountant. If you take on a major client that significantly adds to your bottom line, consult your accountant (if you use one). They can update your projections and let you know if you need to set aside additional funds. If ad hoc interactions aren’t feasible, consider setting up a quarterly or mid-year appointment to make sure your tax planning for the current year is on track. If you handle your own taxes, set aside planning time to evaluate your progress, update your calculations and make any necessary adjustments.
- Consider saving a “buffer” amount. The worst part of being hit with an unexpected tax bill is the liquidity drain — or having to find a solution if you don’t have the cash on hand. Consider increasing your savings for this exact type of emergency.
Freelance taxes can be challenging, even when your income stays consistent. Planning around a variable income takes a high degree of fluency with your tax obligations, regular check-ins and calling in the experts if a big change is disrupting your established plans. However, investing the time to make sure you master your taxes will keep you focused and ensure your business remains financially sustainable over the long term.