Are you a sole proprietor? Working for yourself can be a rewarding experience. You can pursue your passions and live a more meaningful life.
However, you also have to learn about taxes and tax planning as a sole proprietor. You’ll have to pay your own FICA taxes and set up a retirement account, among many other things.
There are four areas of tax planning to consider as a sole proprietor – taxes, retirement, deductions, and healthcare expenses.
What is a Sole Proprietor?
There are different business types, and one is a sole proprietorship.
This is owned by one person and is not a separate legal entity from the business. You get to keep all of your income, but you also are responsible for debts and losses. Your profits and losses are reported on a personal income tax return instead of through corporate income taxes.
Understanding Self-Employment Tax Calculations
When you are a sole proprietor, it is very important to understand taxes and how they are calculated.
When you are employed through an employer, they handle paying taxes on your behalf. It comes directly out of your paycheck. This is not the case when you work for yourself.
You will need to pay federal, state, social security, and Medicare taxes.
The self-employed tax rate for Social Security tax is 12.4%, and Medicare is 2.9%.; a total of 15.3%.
Your federal and state income tax rates depend on what income tax bracket you are in.
There are seven tax brackets – 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
You will need to submit a Schedule C along with your 1040 tax return annually. You will also have to file Schedule SE with your returns and pay taxes quarterly.
Estimating Tax Payments
Since you will have to pay your own taxes, it’s important to estimate your tax payments and make quarterly payments to the IRS.
Ideally, save 35% of your income for tax payments. You want to pay this amount every quarter and on time to avoid any penalties. It’s easier to pay every quarter than one lump sum because this could be a large amount, and you may not have the money when taxes are owed.
It’s better to play it safe than owe the IRS a large sum.
Retirement
When you work for an employer, a lot of things are taken care of directly for you.
Most employers have a 401(k) plan set up for you that you can put a part of your paycheck to and also receive a company match. When you work for yourself, you will have to establish your own employer-sponsored retirement plan.
It’s important to save for retirement, and this can seem like something you could skip on to save money, but the sooner you start, the more time your money has to grow through compound interest.
Some plans to consider for your retirement are:
Do your research on the benefits and drawbacks of each account to find the right one for your retirement goals.
Health Care
Similar to retirement, if you work with an employer, you will have a health care plan chosen for you that you can elect into and pay directly with your paycheck.
When you are a sole proprietor, you will have to find a health care plan that fits your needs.
Different from an employer-sponsored health care plan, you may be able to deduct up to 100% of your health care expenses. You can also set up a Health Savings Account (HSA), and any contributions towards your HSA can be deducted.
These deductions will lower your taxable income, meaning you’ll pay less in taxes.
Business Deductions
To help lower your taxable income, make sure to take into account any business deductions.
Business deductions are very important as a sole proprietor because you will have costs associated with being self-employed, and you don’t want to pay taxes on those expenses.
For example, if you made $100,000 as a sole proprietor, but you bought $20,000 in equipment for your job, you will only owe taxes on $80,000.
Any expenses that are ordinary and necessary can be counted as business expenses. You probably have more business expenses than you realize that can be counted towards business deductions. Use a business account with a separate credit card to easily track these expenses and simplify tax planning.
Tax Planning for the Sole Proprietor
Working as a sole proprietor has you wearing many hats. You are a boss, employer, HR, marketer, and tax expert.
You have to learn all areas of business, and one of them is the tax planning you have to make as a sole proprietor. Understand what taxes you must pay, how to calculate and pay them, any deductions you can make, and other costs that you’ll have as a sole proprietor.