As entrepreneurs, we dream of making it BIG. We hone our skills for years, and sometimes go through 2, 3, 4 or more iterations of our business before it starts gaining traction, all while dreaming of the day that we’ll make $20,000, $50,000, $100,000 per month and more.
And there are a lot of entrepreneurs who have started living that dream “overnight,” after years of grinding it out! I’ve met an author who had been making $30,000 per year and then got a book deal for $500,000 with more books in the pipeline. An executive coach who gained notoriety for one of her offerings jumped from $100,000 per year in income to $2,000,000. And a niche consulting business that got featured on The Today Show launched from $300,000 per year to $300,000 per month!
That jump in income leads to higher monthly spending, paying off debt that’s accrued while building the business, finally paying off that student loan debt, or all of the above! It feels good to buy the things you want and pay off debt, there’s no doubt about it. But that jump in income also leads to a huge change in taxes, more than most people can wrap their mind around when they haven’t previously earned multiple six- or seven-figure incomes.
It’s hard to grasp the magnitude of this change without numbers to go along with it, so let’s look at some illustrations. As a baseline, let’s assume a single tax filer with no children, living in a state with a mid-range income tax rate (3.07% in these examples). We’ll also assume 25% of income can be deducted for business expenses. *Please note, this does not constitute tax advice! Consult with an accountant or CPA familiar with your specific situation for actual estimates of your own taxes*.
Our author was making $30,000 per year from self-employment income, which equaled $4,490 of total tax between federal ($669), state ($642), and self-employment tax ($3,179). When she jumped up to $500,000 her taxes increased to $135,382 in total between federal ($96,545), state ($11,087), and self-employment tax ($27,750).
For our executive coach, when she was making $100,000 per year, she paid $18,544 in total taxes, but jumping to $2,000,000 in one year increased her tax liability to $606,762.
For our niche consultant in a partnership, she earned $150,000 (half of the $300,000 per year mentioned above) and paid $31,046 in total taxes, but when the partnership took off after the Today Show appearance and she started making $150,000 per month ($1,800,000 per year) she owed $543,445 in total taxes.
You might be able to take advantage of some other deductions and credits, and if you are married filing a joint tax return that can lower the tax bill too. But look again at the magnitude of change. Our most extreme example, the executive coach, had an increase in taxes from $18,544 to $606,762 in one year. If you’re at least somewhat aware that such a huge tax bill is possible, you can plan for it, but if no one has ever told you this is even a possibility, it can be shocking to downright panic-attack inducing.
What is the answer, then? Like all financial and tax planning matters, it depends heavily on your personal situation, but there are some basic strategies you can start with as soon as you notice higher monthly profits.
First, don’t go it alone! Find an accountant or CPA and a financial advisor, and make sure they are both experienced in working with small business owners. Your tax situation and retirement savings options are not run-of-the-mill, and you need professionals that can help you plan for both business and personal issues.
Second, make sure that you’re saving a portion of your income into an account specifically for future tax payments at regular intervals. Depending on how you receive income (steady monthly retainers/high volume of small dollar sales/infrequent large payments), you might make transfers to your tax account monthly, semi-monthly, or whenever you receive your larger payments. If you’re reserving 20-25% of your gross income for taxes, you can maintain that percentage no matter what your income is in a particular month and be pretty well prepared for whatever your tax bill ends up being. If you live in a state with no state income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming) you can lower the reserve percentage a little bit, to the 15-20% range. If you get to tax time and you’ve saved too much, you can redirect that money to retirement savings or profit!
Third, consider your options for retirement savings as a way to lower your taxable income, with a goal of putting away at least 15% of your income for retirement. For sole proprietors, a SEP IRA can be a great option if you have cash available. They are easy to set up, can be created and funded at any point up to the tax filing deadline (including extensions), and have higher contribution limits than other types of IRAs. You can contribute 25% of eligible income or $58,000 in 2021, whichever amount is lower. If you are part of a partnership or have employees, talk with your financial advisor about your best options for retirement savings based on your particular situation.
And fourth, if you do get hit with what feels like a gigantic tax bill that you weren’t expecting and can’t pay right away, remain calm! The IRS wants that tax money, but as long as you’re making good faith efforts to pay your taxes, they will work with you to set up a payment plan if you aren’t able to pay in full immediately.
It may feel like you’re putting away a lot of income if you’re saving around 20% for taxes and 15% for retirement savings but being prepared for that tax bill even while you’re experiencing explosive growth in your business makes you even more of a Boss! Once you have a system in place and are confident that your tax planning and retirement savings are on track, you can focus on hitting that next milestone in your business and stop worrying about the financial details.
Hannah Chapman is a wealth advisor based in Cincinnati, OH working with women entrepreneurs and business owners from coast to coast. Connect with her at her website, and on LinkedIn, Facebook, and Instagram.