Physicians have been moonlighting for additional income for decades. But now, “gig work” and “side hustles” are becoming increasingly common — and those terms don’t just apply to rideshare drivers anymore. Professionals across industries are seeking to diversify their income sources by taking on freelance clients and consulting work.
If you are curious about consulting or pursuing work in addition to your W-2 job, even into retirement, beware of disorganization. By creating a separate business entity, keeping your business and personal finances as separate as possible, and planning ahead for tax payments, you’ll be able to integrate a second or third income stream into your life as seamlessly as possible.
Set Yourself Up For Success
As you decide to pursue a secondary income stream, the first necessary change is in your mindset: Begin thinking of yourself as a business owner. Consider whatever income you generate through your consulting or freelance work to be business income. Likewise, classify whatever money you spend to grow your client base as a business expense.
For some business owners, incorporating — setting up an LLC or another legal business entity — may make sense. Creating a distinct entity can offer some liability protection, but it also comes with additional costs. Talk to an attorney about whether or not this step makes sense for your business right now.
Whether or not you choose to incorporate, set up a separate bank account for your business income and expenses. This will make it easier to compile data during tax season. Assign a separate credit card to your business expenses as well. Even if it isn’t a formal business credit card, this will help you make sure you’re paying for your business expenses using your business revenue.
Maintaining separate accounts can also help you manage your money personally. If your business income arrives in your personal checking account alongside your W-2 income, it’s much easier to make a mistake and spend it without setting money aside for taxes.
Put Money Aside for Taxes
Speaking of failing to set money aside for taxes: This is by far the most common mistake I see new business owners make. When you earn income as a contractor, you need to pay taxes out of your earnings throughout the year. If you forget, you might find yourself with a large unpaid tax liability at the end of the year, and you may even owe penalties.
If your self-employment income is relatively small and your employer is withholding a sufficient amount from your W-2, you may not notice this issue at first. But as your self-employment income grows, so will the unpaid tax liability.
Part of the reason it’s so important to have separate business bank accounts is that you will need to allocate a certain percentage of your business income to both federal and state taxes.
Your CPA can help you determine how much you need to dedicate to each liability, because it can vary depending on your state and income level, but 30% is generally a good place to start. If your household income is above $400,000 then you may need to increase this percentage to 35% or even 40%, depending on which state you reside in. This includes both income tax and self-employment tax, which covers your contributions to Social Security and Medicare.
Quarterly estimated tax payments are due Jan. 15, April 15, June 15 and Sept. 15. Most business owners make payments on or before these dates to the IRS and their state tax authority. If you pay more than you owe, you will receive a tax refund when you file your taxes at the end of the year.
I encourage my clients to create a separate account, alongside their business bank account, that is just for taxes. Set up automatic transfers so that you set money aside for taxes every time you receive a check or deposit. That way, when your next tax payment is due, you’ll have it ready.
Plan for a Larger Emergency Fund
Secondary or consulting income is rarely as consistent as W-2 income. If you invoice your clients, it may take a few days or weeks to receive the money you’re owed. You may do a lot of work during certain months and very little during others. Even if your secondary income stream isn’t meant to replace your regular paycheck, it will require you to think differently about your cash flow.
If your business is meant to replace your W-2 income entirely, make sure you have a larger emergency fund. Control your cash flow by keeping excess reserves for spending in months when you have less income or even no income.
Some business owners choose to pay themselves on a schedule the way an employer would — a monthly or biweekly transfer out of their business account and into their primary bill pay account, for instance — to avoid overspending.
If your side hustle is not meant to replace your primary income, then decide how you want to allocate your business income. After setting aside money for taxes and business expenses, use your business income to fund savings goals or pay off debt, just as you would with your primary income.
Look for Tax Planning Opportunities
As a business owner, you may be able to take advantage of opportunities to reduce your tax burden. A financial advisor or CPA can help you navigate this space to maximize your savings while remaining compliant with tax law.
For example, it’s fairly common for business owners to be able to deduct business expenses to offset their business income. If you get audited, however, you’ll need to be able to show evidence of the spending you claimed on your tax return — part of the reason it’s so important to keep your business finances distinct from your personal finances.
Depending on how much income your business generates, you may be able to set up a Solo 401(k) or SEP IRA to save for retirement. If you also have a retirement plan through a W-2 job, talk to your financial advisor or CPA to make sure you understand the rules so you don’t over-contribute.
The tax law changes that took effect in 2018 created an additional tax planning opportunity in the Qualified Business Income Deduction (QBI). This gives business owners the chance to deduct up to 20% of their business income on their individual tax returns. Income limits and other restrictions apply, so again, talk to your CPA about whether you might qualify.
Running a business, even a small one, is thrilling. And knowing you aren’t completely reliant on your employer for income can be a relief. By setting up your financials carefully, you can help ensure that your side hustle or consulting gig remains a source of security, not stress.