Kellett Accounting Solutions Limited
Tax specialists for network marketing and home based business professionals
Saving for tax... A necessary evil? When, and how much?
Putting money aside to pay your tax bill may seem like something you'd rather put off for as long as possible which, if you fall outside of the provisional tax regime, would mean that you're paying the tax on income earned in (for example) April 2012 (which falls into the year ended 31 March 2013) in April 2014.
However, there are two flaws in this approach.
Firstly, when your tax bill finally falls due, it'll be much harder on your cashflow and bank account if you haven't put anything aside. It's almost always easier to find a little bit of money every week or so than a larger amount in one lump sum.
Secondly, if something outside of your control changes, it can change everything. For example, one of my clients had a very nice business with quite a lot of regular income. However, he was really hit hard by the Christchurch earthquake, and because he hadn't put aside money to pay the taxes from the profitable years, he found himself trying to pay large amounts of tax from vastly reduced income streams.
This situation is one that the provisional tax system attempts to address. You pay tax (usually) three times a year (it's different for people who pay GST six monthly, or whose provisional tax is calculated based on their GST returns) so that the date that payment of the tax is due is much closer to the date that the income is earned.
The ratio method of calculation for provisional tax takes this one step further, applying a formula to the income returned on your GST return to figure out your provisional tax on that level of income. (This is ideal if you have income that fluctuates quite a lot. Please feel free to contact me to discuss whether you would qualify for this tax treatment; you need to have been registered for GST on a 2 monthly basis for at least a year).
Regardless of whether or not you have to pay provisional tax, it's definitely worth putting some money aside to cover the both the GST and income tax on your income as soon as you start to have to make regular GST payments rather than receiving refunds. (This is one reason why I recommend that people register for GST before their income hits the $60,000 pa threshold which makes registration mandatory).
The one exception to this is if your income has tax deducted from it before you receive it. This applies to contractors who have withholding tax deducted from their pay. The most obvious example of this is real estate agents. However, since they often have comparatively small expenses, the income amounts can be quite large and they're often registered for GST on a six monthly basis, it's very important that they put away a percentage of their earnings to cover their GST bill.
Your level of expenses (and particularly if your income has an associated cost) will determine whether you should make your tax savings based on your income or on your expected profits. (For example, a real estate agent doesn't have a great deal of cost associated with each commission cheque, or necessarily many overheads, whereas a retail shop will have overheads as well as the cost of purchasing each product sold.)
It's simplest (although not necessarily easy) to just put a percentage of each sale/income payment aside to cover your taxes.
If you're only having to worry about GST (because your income tax is deducted before it's paid to you), then you'd be looking at 15%.
If you need to save for income tax, it's a slightly more difficult calculation, which will involve taking into account all your income (not just the untaxed income from self employment) to figure out the appropriate tax rate (since income tax rates increase as your income increases). Please contact me if you want to discuss the best percentage for you to put aside.
However, there are two flaws in this approach.
Firstly, when your tax bill finally falls due, it'll be much harder on your cashflow and bank account if you haven't put anything aside. It's almost always easier to find a little bit of money every week or so than a larger amount in one lump sum.
Secondly, if something outside of your control changes, it can change everything. For example, one of my clients had a very nice business with quite a lot of regular income. However, he was really hit hard by the Christchurch earthquake, and because he hadn't put aside money to pay the taxes from the profitable years, he found himself trying to pay large amounts of tax from vastly reduced income streams.
This situation is one that the provisional tax system attempts to address. You pay tax (usually) three times a year (it's different for people who pay GST six monthly, or whose provisional tax is calculated based on their GST returns) so that the date that payment of the tax is due is much closer to the date that the income is earned.
The ratio method of calculation for provisional tax takes this one step further, applying a formula to the income returned on your GST return to figure out your provisional tax on that level of income. (This is ideal if you have income that fluctuates quite a lot. Please feel free to contact me to discuss whether you would qualify for this tax treatment; you need to have been registered for GST on a 2 monthly basis for at least a year).
Regardless of whether or not you have to pay provisional tax, it's definitely worth putting some money aside to cover the both the GST and income tax on your income as soon as you start to have to make regular GST payments rather than receiving refunds. (This is one reason why I recommend that people register for GST before their income hits the $60,000 pa threshold which makes registration mandatory).
The one exception to this is if your income has tax deducted from it before you receive it. This applies to contractors who have withholding tax deducted from their pay. The most obvious example of this is real estate agents. However, since they often have comparatively small expenses, the income amounts can be quite large and they're often registered for GST on a six monthly basis, it's very important that they put away a percentage of their earnings to cover their GST bill.
Your level of expenses (and particularly if your income has an associated cost) will determine whether you should make your tax savings based on your income or on your expected profits. (For example, a real estate agent doesn't have a great deal of cost associated with each commission cheque, or necessarily many overheads, whereas a retail shop will have overheads as well as the cost of purchasing each product sold.)
It's simplest (although not necessarily easy) to just put a percentage of each sale/income payment aside to cover your taxes.
If you're only having to worry about GST (because your income tax is deducted before it's paid to you), then you'd be looking at 15%.
If you need to save for income tax, it's a slightly more difficult calculation, which will involve taking into account all your income (not just the untaxed income from self employment) to figure out the appropriate tax rate (since income tax rates increase as your income increases). Please contact me if you want to discuss the best percentage for you to put aside.