Episode 46: Figuring Out Your Finances and Taxes as a Freelancer with Aaron Rubin
Chad:
I'm excited to talk to Aaron today because he is a financial expert and CPA. He knows a lot about investments and taxes, and as a freelancer, you need to be able to position yourself properly. I made a lot of mistakes when I was first freelancing. When I had to file for taxes after my first year, it was a huge headache.
Aaron's here to help you prevent those types of mistakes. We're going to discuss today how you can prepare your financial life to be able to support your family safely while starting a business and being self-employed.
Aaron, would you like to introduce a little bit more about what you do, how you got into this, and what your real focus is with your business?
Aaron:
Sure. Thanks for having me on the show. My business is a financial planning business/investment practice. We work a lot with individuals at pre-IPO companies, but we also have lots of people who are not in that pre-IPO. But again, we're in Silicon Valley, so we see a lot of it. I wrote a book called “Financial Adulting” and it really tackles a lot of the issues that you're bringing up.
So I got into what I do sort of by accident. I was in law school and met my wife while I was in law school. And my father-in-law said, “Hey, how would you like to do what I do?” He was in financial planning, and I said, “Well, sounds sort of interesting. You know my background is as a CPA.”
So I sort of had all of the right background for getting into financial planning, and that's what I eventually did. I've loved it. I spent three years in public accounting, so I had a nice season there, but I do not miss the busy season hours and all the other stuff that comes with that. So I'm pretty happy.
Chad:
Very good. Thanks for letting us know about that. I'd love to know more about some of the key points that you teach in your book for young people. People who are in their twenties, they're getting ready to either graduate college or already have, and they're trying to figure out their financial life.
I know in my experience, I was very unprepared for understanding how to figure out my finances. What are some of the key points that you discuss in that book, “Financial Adulting”, that you can share with this audience that they'd be able to benefit from?
Aaron:
So to me, the most important chapter in “Financial Adulting” is chapter one. And that’s not by accident because chapter one is all about creating a budget. If you want to know where you're going, you have to know where you've been and where you are. The best way to do that is by creating that budget. It's the most crucial piece of any financial plan that occurs. Even my own financial plan.
So even just this weekend, my wife and I were like, “Hey, you know, let's get a handle on where things are now. Let's go through a credit card, which is horrendous, and let's, you know, pick out what's there, what are we spending our money on and what can we change?” Cuz you can't change anything unless you know what it is that can be changed. So budget is step one for sure.
And then once you have that budget, you need to build things into that budget. So again, having an emergency type fund, like six months of expenses just built up that you can burn through in case things slow down for you. And again, just being prepared for those sorts of things
Chad:
When it comes to having a budget, how would you advise someone? Pretend that you're speaking with someone in their twenties, just trying to start their own freelance business. They've got some bills, they have a small family. How would they go about creating a budget and what are some elements of that budget that they need to have?
Because there are a lot of different approaches to budgeting. How do you break it down, whether it's just big chunks going to this or breaking it down even further, especially when you're not going to have consistent income? They're getting clients one month that earns them $5,000. Then the next it's $8,000. How do you budget when your income might not be consistent when you're just getting a business going?
Aaron:
Carefully. Having that cash cushion for the leaner months that are bound to happen is key. So when you're looking at that budget, I try to get as granular as I can category-wise. I think it's sometimes we get frustrated and we say, “Okay, well I'm just gonna lump this into entertainment.”
Entertainment gets so much stuff, but you can throw lots of stuff at entertainment, but if you're not breaking it down beyond that, you're not doing yourself any favors. All you're doing is creating a number that is virtually meaningless. That's very hard to impact on the margins if you don’t break it down.
I mean, you don't have to, you don't have to break it down between Starbucks and Petes. But you might have a coffee budget. I tend to go to Starbucks and for anyone who wants to buy me coffee, by the way, I get a doppio macchiato, it's $3.05 every time I go, and I go pretty dang consistently.
So I have a real coffee budget. My wife doesn't necessarily have that same thing. But starting with breaking it down as small as makes sense will help you get to that final number that you need.
Chad:
Yeah, that's definitely helpful. In my own experience, budgeting is an ever-evolving thing. Sometimes we switch up what we're doing and then a year goes by. Now we have different priorities. So the first thing we have to do is really figure out where we're at, and where we've been.
How should someone in their twenties starting a business financially plan as they're projecting forward?
So you have the budgeting side, and then you have the financial planning side. What should be in a financial plan that gives you a clear path so you have the right kind of goals and you know what you're trying to work towards? What do you normally recommend, especially for someone that young? Do you plan all the way till retirement? Do you just plan for the next five years? How do you approach that?
Aaron:
When you're in your early twenties, you have no idea what your expenses are going to be like when you're closer to 50 or 60. It's an impossible task. But, you do the best with the information that you have, right?
There are certain goals that you try to set for yourself. Goal number one should be, you want to save for the future. And so you pick a number that stretches you a little bit. If you want to save $5,000 a year eventually, part of your process should be maxing your 401k or your step IRA depending on where you are at from a freelance perspective. Then you work towards those big stretch goals.
And in the beginning, you might not be able to max your 401k. I mean, it's a great goal, but it may not be feasible. But it's one of those things where you build it into your budget now and maybe it's small, maybe it's really small, maybe it's $500 a year. That's okay. Because then what happens then is hopefully as your income keeps growing, you’ll know that if your income goes up by 20%, you need to increase your 401k contribution by 20%. So you need to link those things together.
But if you never start with a 401k goal or with a 401K actual deposit, then you're never gonna increase it because it never existed. So you have to get it on paper and you have to make it reality before you can really start planning for maxing it out and meeting those financial goals.
Chad:
Yeah, that makes sense. So there's some level of plan that has to go into place, but you can't necessarily say, “Hey, my budget when I'm 60 is gonna be this.” There's really no way of knowing that in the first year someone just shifted to self-employment.
How should they prepare themselves when tax season comes around? Everything from how they do their bank accounts, to tracking their expenses? What's going to make them avoid having a huge, huge headache when it comes time to do their taxes? Does that involve bringing in a CPA before tax season? What kind of things does this person need to do?
Aaron:
It depends on how much time you have. When you're hiring a CPA or an accountant of any sort, you're outsourcing. And whenever you’re outsourcing, you're saying, “I don't have the time or maybe the capacity to do this.” So it can totally make sense early on to bring in an accountant of some sort, but you're still going to have to track all your income and expenses because that's where everything's going to start.
There are some great tools out there. QuickBooks has some nice features like taking pictures of receipts and making it as painless as possible. But there's always going to be time that you're going to burn doing bookkeeping type stuff. But as you get bigger, maybe you DO hire a bookkeeper and you just give them the shoebox to go through and they just do it for you.
But certainly, you want to keep your eye on those taxes, because you're going to owe tax every quarter. It's based on what your liability is going to be. Although you can avoid penalties with prior year safe harbors and that sort of thing. I'm not going to get bogged down there. But I've seen people make huge mistakes with their quarterly taxes when they pick an arbitrary number.
You need to know what your tax rate is. You need to know because you're going to owe self-employment tax. That self-employment tax is north of 15%, so you better be prepared. Whatever your income tax is going to be, you’ll need to add on another 15%.
When you have a preparer, you can get really granular, and really get the number right. But if you're just starting out, you can definitely pop open TurboTax, plug in some numbers, and see what it's going to be.
Chad:
Estimated taxes really confused me at first. I had years initially when I wasn't bringing somebody in to help and I estimated it based on this certain month and it was wrong. Then I owed more at the end of the year. Are there tools that a freelancer can rely on to help figure that out or do they really just need to hire someone to help with that?
Especially if it's like year one. Do they even pay estimated taxes in the first year? How do you not get penalized if you don't know what your income is going to be throughout the whole year? Or what do you do if it's different the first half of the year than it is the second half of the year?
Aaron:
So for example, if it's your first year freelancing in 2022, and you came from a regular W-2 type of job for the year 2021. So for the 2021 year, you had a tax liability based on your W-2. Let's ignore the State taxes for now because I don't know what State you're in. So let's keep it Federal.
Now, for that first year, you take a look at your Federal and if you're under $150,000 of gross income, you end up owing a hundred percent if you want to avoid a penalty. If you pay in 100% of the prior year's tax return’s tax amount, you can avoid the penalty.
If you're over $150,000, it's 110% of the prior year or alternatively 90% of the current year. So depending on your adjusted gross income, what your safe harbor is from the prior year or 90% of your current year, in which case, you know, you're going to have to put pencil to paper to do that sort of calculation.
When your cash flows are so irregular, what I've done in my life is every quarter I just go through and I say, “Okay, my first quarter was this, I'm gonna assume that it's going to be the next four quarters like that.” Okay, now the second quarter happens. Now I tune it up to reality. Okay, so now I have two quarters that were like this and now I'm gonna assume the following two quarters are going to be the same way. And then you get to the third quarter and you say, “Okay, you know, based upon my three quarters, my average is whatever it is for the three quarters, it's probably gonna be my fourth quarter.” So you do the best you can there and you pay in as you go.
If you are in a situation where it's highly irregular and it's really, really far off, there are different methods to reduce penalties. You can do an actualization for cash flows in the IRS and I think you'd break it down either quarter by quarter or month by month as to how much your income was in any given set of time so that you can abate your penalties because your cash flow is so irregular.
Chad:
Okay, gotcha. Now, what if you paid a lot less in estimated taxes for the first six months of the year than you’re expecting in the second half of the year? Your income was much higher in the second six months, so then you ended up paying a much higher amount.
But by the end of the year, if you've paid over, is it like as long as you pay 90% of what you owed you avoid the penalty? Is that what it is?
Aaron:
Yeah, so you have to pay 90%, but generally, unless you've calculated otherwise, it has to be rateable. So let's say your tax liability is $100,00 for 2022. That means for 2022, you have to have paid at least $90,000. Without triggering an exception, the IRS expects you to pay $90,000 divided by four, which is $22,500 per quarter.
But if you can show them that's not how your cash flow really worked, it was a lot leaner the first six months and then you got a lot the next, (and you have to show them those cash flows) then you can abate the penalties because they'll let you match your cash flows to your tax payments.
Chad:
Okay. So they still look at it by quarter to see if you paid the appropriate amount, even if you paid the full amount by the end of the year. If you don't pay a certain amount in each quarter, you’re in trouble. They're just assuming you're earning the same amount all year or the same amount each quarter, then you get penalized for that specific quarter on what you paid, and how much under it was.
Aaron:
Yep. And just to confuse everyone as much as I can, that's actually not the case with W-2. W2 is considered rateable no matter when the withholding happens. So let's say you owed $90,000 for the year and you, and for some magical reason you withheld $90,000 on December 31st.
The IRS treats it as if you made that $90,000 payment as a $23,000 payment every quarter, even though you waited till the last day of the year to do the withholding because withholdings are treated differently. So business owners and freelancers have it hard
Chad:
Yeah. And I think it is harder depending on how you’re set up. I've always been an “owner.” I don't pay myself a W-2 salary, it's just self-employment tax for the LLC.
That's really helpful. Are there any other specific points that you wanted to discuss that you thought would be helpful to our readers? Especially if they are a young parent with a family trying to get a freelance business going? You've already shared some really great tips on how to make sure that we are prepared enough for tax season and how to create a budget. Any others that you think would be helpful to discuss as we wrap it up? Maybe something from your book?
Aaron:
Gosh, I've got nine more chapters in the book, so I've got lots of ammunition. If you're freelancing, especially if you're on the younger side of freelancing, maybe under 35 or 30, there are certain estate documents that you really need to have in place. I’m really passionate about this. You need to have power of attorneys available in case something happens to you. Someone's going to make decisions for you financially or for your medical care, and you need to have that sort of thing figured out legally. I've seen so many people come into my office that just have nothing. They have kids, and they have no wills, they have no trust, they have no documents whatsoever.
But there are some things you just have to have, like powers of attorney. And if you have kids, you HAVE to have a will. If you love your kids, you're going to have a will. You may want to see an estate planning attorney anyway, so go ahead and get that squared away. And then I'd say, don't be afraid to ask for help.
We talked about hiring a CPA or some sort of accountant or tax preparer. It can be expensive, but the tax code is complicated. That's why you pay them the money, right? That's why they charge $350 an hour, because they're experts at it. Your typical freelance person, unless they're a freelance tax accountant, they don't really know all the different rules. You don't know what you don't know and that's where it can get scary.
Chad:
That's really helpful. That's something I had to do, and I definitely encourage you to hire that out. I hired a CPA to get things organized and a lawyer to make sure the estate planning and wills were in order.
Do you have any advice on how to structure your business when you’re married? Let's say you have an LLC you’re self-employed and you're the only one working and your wife is not. Should you split ownership in your company even though she's not actively working? In our case, that’s how we have it structured, and we have a trust that has some ownership as well.
What do you think is the most beneficial structure for your family if something were to happen to somebody or just so that the business doesn't just go off to somebody not in the family?
Aaron:
Yeah. I think you need a healthy dose of realism. Is your spouse equipped to do what you can do and can keep it going if something happens to you? Or are they equipped to wind it down? Because sometimes they're not. We have trustees that we work with who will help businesses do that wind-down process. So if you have a bigger business that is complicated, and if something happens to you, you need a plan.
That’s especially true if you're the only person who can do your job, and you don't have a buy-sell agreement with somebody else, or anything like that. In those cases, there are trustees who will step in and do that sort of thing, but you try not to get it there.
Having arrangements prior to the event is always key. I have two other partners. So if I get hit by a bus tomorrow, they're taking over. They're getting some of my revenues, and they could hire someone else to help with all the workload, but there’s a clear plan in place. You need to think through, “Okay, if I'm no longer here, what's gonna happen? Who can take over for me?” And maybe you need to have additional insurance, like life insurance in place to help defray some of the costs that you're gonna create by untimely dying.
Chad:
Yeah, that’s great. You’ve shared a lot of great tips about taxes and finances and I definitely encourage people to go get your book “Financial Adulting.” Is that something you can find on Amazon or is there a website?
Aaron:
Yeah, Financial Adulting is definitely on Amazon. Some jerk recently stole my title. I published it like three years ago and someone just came out earlier this year and just used my title. And it was like a real publishing company too. I'm like, “Didn't you do an Amazon search before you did this?” Anyway. But my cover's a lot cooler. It's got a paper airplane on it and it looks awesome.
Chad:
Okay, great. Well thank you so much Aaron, and we appreciate everything you shared with us today!
Listen: