Breaking Down Your Personal Income Taxes
Income taxes are what most people think of when I say “taxes.” It’s generally the biggest tax bill people owe each year. This tax is how the federal and many state governments are funded.
All US workers and US citizens abroad pay income taxes. It gets complicated when we look at businesses and business owners. Unless you are a C-Corporation, your business does not pay federal income taxes (some states vary, but most mimic the Federal government’s). In most legal structures, including sole proprietors, LLCs, s-corporations, and partnerships, the income will “pass-through” to the owners who will report the income on their personal income tax return.
How income taxes are paid is convoluted. I’ll break it down into three buckets: self-employment taxes, estimated taxes, and withholdings.
Self-employment taxes
Good news! Self-employed people are able to collect Social Security and Medicare when they retire. That’s because they pay into the system through what’s called “self-employment taxes.
In a traditional job, employers withhold money from an employee’s paychecks to cover these taxes. Employers are also required to match those contributions. As an entrepreneur, however, you don’t have an employer that’s withholding your contributions or matching them. That means you are responsible for paying both “sides” of the Medicare and Social Security taxes, which get bundled under the term self-employment tax.
The total amount of self-employment tax that you owe is 15.3%. In most cases, this is calculated based on your net income. Remember that these self-employment taxes are owed in addition to income taxes. So if you’re paying your taxes as a sole proprietor, you’ll owe both income taxes and self-employment taxes on the money you make from your business.
Estimated taxes
Since most business owners are not paid via payroll, the IRS offers a different pay schedule. These payments are called estimated taxes. These payments cover both income taxes and self-employment taxes. Estimated taxes are due approximately every quarter.
To figure out how much to pay, you may need to reach out to a professional to create a tax plan, use software like QuickBooks Self-Employed, or look at your last tax return.
When you file your tax return, your preparer or the software will assume your income will be about the same next year. They’ll use that info to draft estimated tax vouchers for the next tax year.
If you make more or less than the previous year, you may need to adjust your numbers. Again, a tax preparer (like *moi*) or an app can recalculate for you.
In theory, these upfront payments will make it so you don’t have a huge tax burden the following year.
You should get vouchers for estimated taxes if you owe more than $1,000 in income and self-employment taxes. If you prefer to do your own taxes, consider using QuickBooks Self-Employed. This app tracks your income as you earn it and to calculates how much you should pay.
Withholding tax
The first way to pay income taxes is also the most familiar. Anybody who’s ever been an employee has personal experience with withholdings. However, most business owners won’t pay their own taxes this way. It’s only relevant if they have payroll and employees.
Via payroll, employees have their income taxes automatically deducted from their paycheck. The employer calculates how much taxes the employee will owe, pays them the difference between their salary and taxes, and remits the taxes to the appropriate government agency. The same happens for Medicare, Social Security, and any state taxes.
Employers have to match their employee’s Medicare and Social Security taxes, plus pay unemployment taxes.
As you can imagine, calculating all these taxes for each employee, withholding the money, remitting it to the government, paying everyone the correct amount, on time, and keeping all the documentation straight, is insanely difficult.
It’s time-consuming and prone to error. Unfortunately, making a mistake in your payroll tax calculations can be very expensive – in 2014 alone, the IRS collected over $2 billion in fines from small businesses due to mistakes and omissions.
Please, please do not DIY payroll. Don’t hire someone to crunch the numbers either. It’s not worth the risk.
The savvy choice is to use a payroll service. My favorite is Gusto. It’s super affordable and easy to use. Gusto takes care of all the calculations, payments, reports, records, and deposits so you don’t have to. It helps you avoid pricey errors and saves you tons of time and money. In fact, it can reduce costs by up to 80% compared to doing payroll manually.
Don’t forget another tax deadline
This plan will help you track your financial and tax to-dos, so you’ll never be blindsided by a tax payment you didn’t expect again
Now that you have a grasp on what income taxes are and how to pay them, it's time to talk business taxes. Check out my blog on common types of business taxes to discover what you need to know.