How to Set Next Year's Tax Set-Aside Percentage
On $60,000 of profit, setting aside 30% when you needed 22% ties up $4,800 you could have used. Setting aside 20% when you needed 28% leaves you $4,800 short in April.
Same business, same year, same $4,800. One version is money you could not reach. The other is a bill you cannot pay.
Everybody says 30%. For a lot of self-employed women that is too much, and for some it is nowhere near enough. The percentage is not a rule of thumb, it is arithmetic, and by the end of this you will have your own.
This is the right week to do it, because you now have nine months of real numbers and still have three months to adjust.
The short version
Your set-aside is two taxes added together: self-employment tax and income tax.
Self-employment tax is 15.3% on 92.35% of profit, which is about 14.1% of profit.
Income tax depends on your whole household, which is why 30% fits some people and not others.
Move the money on the day it arrives, not at the end of the quarter.
What you are actually setting aside for
Two separate things, which is where most of the confusion starts.
Self-employment tax. This is Social Security and Medicare, and it is 15.3%, charged on 92.35% of your net earnings. It starts from the first dollar of profit. There is no threshold below which it does not apply.
Income tax. This depends on your total taxable income, your filing status, your deductions and your state. It starts low and rises in bands.
So your set-aside is self-employment tax, which is fixed and predictable, plus income tax, which is not.
How to work out your own percentage
Take your business profit for the year so far. Revenue minus the expenses you can evidence.
Annualize it. Nine months of profit divided by nine, times twelve.
Work out self-employment tax: profit × 0.9235 × 0.153.
Estimate income tax on your total household taxable income, including anything your spouse earns.
Add the two, divide by your profit. That is your percentage.
The reason 30% is so often wrong is step four. A woman with modest profit and a spouse's income already using her lower bands has a very different answer from a woman whose business is the only income in the house.
What lowers it
The fastest way to reduce the set-aside is to stop missing deductions. Every expense you can evidence lowers profit, and lower profit lowers both taxes at once.
Commonly missed | Where it lands |
|---|---|
Home office, actual or simplified | Schedule C |
Mileage between work locations | Schedule C |
Phone and internet, business share | Schedule C |
Software and subscriptions | Schedule C |
Education that relates to work you already do | Schedule C |
Bank and card processing fees | Schedule C |
Professional insurance | Schedule C |
Half of your self-employment tax | Adjustment on Form 1040 |
That last line surprises people. Half of the self-employment tax you pay comes back as an adjustment to income.
Set it aside on the day, not at the end of the month
A percentage you calculate perfectly and move quarterly is worse than a rough percentage moved on the day the money arrives.
Money that sits in the account gets spent. Not recklessly, just ordinarily, on a repair or a slow month. Move it the day it lands and the question never comes up.
Do it with your own numbers, free
Step one asks for your profit for the year so far. That is the step where most people stop, because it means adding up nine months of bank statements by hand.
La Soglia, the free membership of the Money Mastery System, holds what you own and what you owe with no bank connection and no card. When the profit figure is the part standing between you and your own percentage, the categorization in the paid membership is what produces it, and Clarity remembers how you sorted something last time so you are not making the same decision twice.
The Money Mastery Collective comes with the free membership too, and this question comes up there every autumn.
Questions we hear
Is 30% ever right?
Often, for a sole earner with healthy profit and few deductions. It is a reasonable place to start and a poor place to stop.
What about state tax?
Add your state's rate to the calculation. Some states have none, which changes the answer considerably.
What if I set aside too much?
You have savings. This is the good version of being wrong, and it is worth aiming slightly high in your first year of doing it properly.
Do I pay quarterly?
Most self-employed people are expected to, and underpaying can carry a penalty. The set-aside is where the quarterly payment comes from, so the habit and the obligation fit together.
Should I keep the set-aside in a separate account?
Yes, if you can. Money that sits with everything else gets counted as available. A separate account is what makes your operating balance true.
What if my income changes a lot from month to month?
Use a percentage, not an amount. A percentage sets aside a little in a slow month and more in a strong one, and the total comes out right either way.
References
The self-employment tax rate of 15.3% applied to 92.35% of net earnings, and the deduction for half of it, are from the IRS Schedule SE instructions and IRS Tax Topic 554. Expense categories follow the IRS Schedule C instructions.
Bring it to the Collective
Working out your own percentage is the kind of thing that goes faster with somebody to check it against. The Money Mastery Collective has a discussion feed open to free members, and this question comes up every autumn.
Start free with La Soglia
La Soglia is the free membership of the Money Mastery System. It gives you the Net Worth Tracker, where everything you own and everything you owe sits in one place, and the Money Mastery Collective. There is no card to enter and no bank connection.
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A note on what this is
This article is educational. The Money Mastery System is an educational tool, not financial software, and nothing here is legal, tax, investment or financial advice. Tax rules change, vary by state and depend on your whole situation, and nothing here is a substitute for advice from someone who knows your return. For guidance on your own circumstances, please speak with a qualified professional who knows them.
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