Freelancer Finance, Part 1: What Is Your Actual Income?

When I was working for a company, I knew my salary off the top of my head. But when I started my own freelance editorial business, things got a lot more confusing.

Even though I did my own taxes for years and thought I had a solid understanding of my LLC’s finances, I still preferred to think of my income as the company’s revenue, instead of what I was actually able to pay myself.

I’m here to share a valuable financial lesson that took me far too long to fully understand: your business income is not your personal income.

So what are you actually making in a year? Let’s take a look.

GLOSSARY

Before we dive in, here are the terms you’ll need to know in order to calculate your actual income:

• Revenue, a.k.a. gross income or sales: Your total sales.
• Business expenses: Rent, utilities, office supplies, advertising, legal fees, subcontractor payments, travel, health insurance, and any other costs of doing business. (Don’t include tax payments as an expense.*)
• Profit, a.k.a. net income or net profit: What’s left over after all your business expenses have been paid.
• Tax rate: The percentage at which the federal and state governments tax your company.
• Total taxes: The total amount you pay in federal and state taxes in a given year.
• Actual income, a.k.a. salary or draw: What you can pay yourself after paying taxes, taking care of all the costs of doing business, and making sure there’s money left over to pay future expenses. (More information on salaries vs. draws here.)

WHAT IS YOUR ACTUAL INCOME?

Here’s how to find out what your actual income is in a year. I’ll use my LLC as an example here, but with fictional dollar amounts. (If you have another business structure, such as a sole proprietorship, these calculations may differ.)

The year is already over in this scenario, so this will be used to estimate how much I’ll be able to pay myself in the coming year, assuming my revenue stays about the same.

STEP 1: CALCULATE PROFIT

Let’s say I had $63,000 in sales last year. Using the equation below, I can calculate my company’s profit for that year.

Equation to Use

Revenue – Expenses = Profit

Crunching the Numbers

Revenue: $63,000

Expenses (I don’t include tax payments in this*): $33,000

Profit: $30,000

Voila! Now I know my profit. (This is an estimate, since I haven’t taken all of the IRS’s business-expense rules into account, such as only deducting 50% of the cost of meals. But it’s close enough to be useful without being confusing.)

STEP 2: FIGURE OUT TOTAL TAXES

Next, I can determine roughly how much I’ll owe in taxes for the past year. Taking a look at the past few years of tax forms, I can see that I pay approximately 25% of my profit to the IRS every year. I also know that I pay another 4.63% of my profit to the state of Colorado.

Note: Your federal tax rate depends on your taxable income and your business structure. State tax rates vary by state—Colorado uses a flat rate, and some U.S. states don’t collect state taxes at all.

Equations to Use

Profit x (Federal or State) Tax Rate = Taxes

Federal Taxes + State Taxes = Total Taxes

Crunching the Numbers

Federal Taxes

Profit: $30,000

Tax Rate: 25%

Federal Taxes: $7,500

State Taxes

Profit: $30,000

Tax Rate: 4.63%

State Taxes: $1,389

Total Taxes

$7,500 + $1,389

Total Taxes: $8,889

I can therefore expect to pay around $8,889 in taxes for last year, based on my estimated business profit. (I pay quarterly estimated taxes, so I don’t pay a huge lump sum in taxes come springtime. Estimated taxes are often mandatory for business owners—make sure you pay them! I use eftps.gov to set up automated quarterly payments online.)

Note: Once you know your federal and state tax rates, you can also combine them into a “total tax rate” to make this calculation even simpler. My total tax rate is 29.63%.

STEP 3: DETERMINE ACTUAL INCOME

Now it’s time to figure out how much is left to actually pay myself.

Equation to Use

Profit – Total Taxes = Actual Income

Crunching the Numbers

Profit: $30,000

Total Taxes: $8,889

Actual Income: $21,111

Note: this doesn’t include payments to business retirement accounts or savings accounts, which are critical to your financial future.

FACING FACTS

Does the actual income number above seem low? It did to me, too, when I first started calculating what I was really earning. Although the numbers above aren’t representative of my actual personal sales or income, I found out that I needed to make some serious changes to my business in order to be able to pay myself more.

The moral of this story? Your business income is not your personal income.

Stay tuned for Part 2 of this series, where I’ll talk about the importance of separating your personal and business accounts, and how to financially prepare for the peaks and valleys of freelance income.

* Why don’t I include tax payments in my business expenses? Because the government uses a company’s profit, not its revenue, to determine how much to charge in taxes, and it doesn’t include tax payments as a deductible expense. Not including tax payments as part of my business expenses gives me a clearer picture of my profit from the government’s point of view, which helps me see what I’ll actually owe. However, if you're only looking for a basic estimate of your total profit, including taxes as part of your business expenses is OK. 

Craving some support with all this number-crunching? My Advanced Freelance Rate Calculator makes it easy to see how much you'll need to charge to break even—and how much you'll need to charge to be able to save for retirement and other goals. It also factors in payment processing fees!

The information provided in this article is for informational purposes only, and it should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs.