Advice like "set aside 30%" is popular because it is easy to remember. It is also wrong for many people. Your right number depends on profit, entity type, and state. Here is how to estimate your own.
Why one percentage fails
- Tax is calculated on profit, not revenue.
- Self-employment tax applies to sole proprietors and partners but works differently for S corporation owners.
- Federal brackets are progressive, so the rate changes as profit grows.
- State and local taxes range from none to substantial.
- Deductions and credits change the result.
The components to estimate
- 1Self-employment tax, if you are a sole proprietor, partner, or single-member LLC owner.
- 2Federal income tax on your taxable income.
- 3State and local income tax.
- 4Sales tax and payroll taxes you collect or withhold, which are not your money and should be held separately.
Worked example: self-employment tax (hypothetical)
Self-employment tax is 15.3%, made up of 12.4% Social Security tax (up to an annual wage base limit) and 2.9% Medicare tax. It is figured on 92.35% of net earnings from self-employment. Suppose net profit is $80,000. Net earnings are $80,000 × 0.9235 = $73,880. The tax is $73,880 × 0.153 ≈ $11,304. Half of that, about $5,652, is deductible when figuring income tax. This figure is before federal and state income tax.
Federal income tax depends on your filing status, other income, and deductions, such as the standard deduction and any qualified business income deduction you qualify for. State rates vary. A professional can project these for you, and tax law changes, so do not assume last year's brackets apply.
A practical set-aside system
- 1Open a separate savings account for taxes.
- 2Move a fixed percentage of every deposit as it arrives, using a conservative estimate from your accountant.
- 3Hold collected sales tax and withheld payroll taxes in a separate account from your income tax savings.
- 4Pay estimated taxes quarterly from that account. See quarterly estimated taxes for LLC owners.
- 5True up the percentage each quarter after reviewing your profit and loss.
Avoid underpayment penalties
The IRS says most taxpayers avoid an underpayment penalty if they owe less than $1,000 after withholding and credits, or if they paid the smaller of 90% of the current year's tax or 100% of the prior year's tax shown on the return. Higher-income taxpayers face a higher prior-year percentage, so confirm the rule for your income.
S corporation owners are different
If you own an S corporation, part of your income is wages with withholding, and the rest flows through as profit. The set-aside is typically smaller as a share of total income, but not zero. See S-corp reasonable salary.
Our tax planning service builds a personal estimate and quarterly plan. To get started, schedule a business tax planning consultation. This is general information; actual liability depends on your circumstances.
