Hi Reader,

Last week I broke down where our extra income comes from. This week I want to talk about the part that doesn't show up in the exciting "I made $2,000 this month" version of the story.

When you're self-employed, even partially, a chunk of that income isn't really yours.

The tax on freelance income

W-2 income has taxes taken out before you ever see it. Freelance income doesn't. The full amount lands in your account, and it feels great, but somewhere between 25% and 35% of it needs to be set aside for taxes, depending on your situation. For me, that means when I bring in $1,253 in a month from contracts, I'm mentally marking somewhere around $300 to $400 of that as untouchable.

On top of regular income tax, self-employment income is subject to self-employment tax, which covers Social Security and Medicare. As a W-2 employee, your employer covers half of that. When you're the employer, you cover all of it. That's an extra 15.3% on top of your regular tax rate before you even get to federal and state income tax.

This is exactly how we ended up with the tax refund situation I mentioned last week. I overestimated what I'd owe because I underestimated how much I'd earn. Getting ahead of this is why I make quarterly estimated tax payments now instead of hoping it works out at filing time.

What I actually set aside

I keep a dedicated savings account for self-employment taxes. Every time a freelance payment lands, I transfer a percentage out immediately before it has a chance to get absorbed into regular spending. Out of sight, out of mind, until quarterly payments are due.

It's not a complicated system, but it only works if you do it automatically and immediately. The worst version of this is spending the money and figuring out taxes later.

The tools I use to manage all of this

I get asked pretty regularly what tools I actually use to run the financial side of things, so I put together a start page on my website that shows everything I'm currently using and what I'm paying for each one. You can find it here.

The short version for the money side:

• Every Dollar (Pro) for budgeting, which is what I walked through last week
• Bluevine banking for invoicing my freelance clients
• Toggl for tracking hours on the hourly contract, so my invoices are accurate

The point

Freelance income is worth it. Both of my contracts are worth it. But going in with accurate expectations about what you actually keep matters a lot. Going forward, I'll always talk about my freelance income and how I'm using it, but keep in mind that the gross amount isn't the amount I'll actually transfer into my personal bank account.

I have business expenses that come out every month. I have savings I set aside for marketing and gifting, and I have tax savings I fill with every payment.

If you're thinking about picking up any kind of contract work or self-employment income, build the tax savings habit before you need it. It's a lot easier than trying to find money you already spent.

Talk soon,