Business Expenses and Self-Employment Taxes in the 50/30/20 Rule

When you’re creating a budget based on self-employment income, you need to make some tweaks to traditional budgeting methods. The concepts are the same, but personal budgeting rules like the 50/30/20 rule don’t take into account things like business expenses and self-employment taxes. Here’s what you can do to adapt your budget.

This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.

What is the 50/30/20 budget rule?

The 50/30/20 budget rule is one of the most popular personal budgeting rules. It breaks your monthly budget into three main categories.

  • 50% goes to bills and necessities. That includes your rent or mortgage payments, car payments, groceries, utility bills, and anything else that you have to pay. It also includes minimum payments on your debt.
  • 30% goes to discretionary spending. This can range from routine purchases like eating out to big spending like vacations.
  • 20% goes to savings and paying off debt. This includes building an emergency fund, growing your retirement savings, and extra payments on your debt. Extra debt payments count as savings because paying interest on your student loans and credit card debt is a form of negative savings.

The percentages are based on your after-tax monthly income. However, some people just use their take-home pay. That means things like health insurance premiums and 401(k) retirement contributions won’t be accounted for in your budget. That can actually be a good thing if you’re contributing to a 401(k) and then saving another 20% on top of that.

How does the 50/30/20 rule change when you’re self-employed?

There are three things independent contractors need to take into account when using the 50/30/20 rule.

You’re budgeting pre-tax income.

The 50/30/20 budgeting rule uses income after taxes, but since you pay estimated taxes instead of withholding, some of the money that hits your bank account needs to go to taxes. With 15.3% in self-employment taxes and 10% to 37% in income taxes, you can’t include taxes as part of the 50%.

You have business expenses to pay.

Most people will have business expenses to pay. Your actual paycheck is your income after expenses.

Again, including business expenses in the 50% necessities categories will skew your numbers. You also don’t want to get into the mindset of cutting business expenses to meet a personal budget rule if taking on those expenses is helping you make money.

You have variable income.

A fixed percentage rule of thumb is good when you have a stable income but not when you have up and down months. If it’s a down month, you don’t want to put 30% on wants only to find out you don’t have enough left over to meet your monthly expenses.

How do you adjust the 50/30/20 rule as a freelancer or independent contractor?

You can easily adjust the 50/30/20 rule by making a few adjustments. The goal is to figure out what your paycheck is and then budget based on that amount.

To make this rule easy, it’s best to have all of your income deposited into a separate business checking account. If you’re an independent contractor, you can open up a second personal checking account and use it for your business income.

Pay your business expenses first without budgeting.

Your business expenses shouldn’t be in your personal budget. That’s not to say you shouldn’t have a business budget or analyze your business expenses, but you should keep your personal and business budgets separate.

Pay all of your business expenses out of your business checking account. If you have expenses you put on a credit card, open up a separate business credit card you pay from your business checking account.

Set aside money for taxes next.

Next, you should either make your estimated tax payment or set aside money for estimated taxes. Some people use 30% (but this is not the 30% in the 50/30/20 rule). Some people figure out their effective tax rate from their previous year’s tax return. Some people add a little to their previous year’s tax return.

This is just like figuring out tax withholding at a salaried job. If you’re not ready to send a payment to the IRS, move your tax money to a separate account. You can use a high-yield savings account and then direct debit your quarterly tax payments from that account.

Now pay yourself.

Whatever is left in your business checking account after you paid your business expenses and taxes is your paycheck. Send 20% to your retirement accounts or savings account. Send the other 80% to your personal checking account and spend it according to your budget. Some people like to use an extra personal checking, so 50% goes to their bills checking account and 30% goes to their wants checking account.

Example 1 (Easy Math)

You received $1,500 in your business account. You had $500 in expenses.

  1. Pay $500. You have $1,000 left in your business account.
  2. Set aside 30% of the remaining $1,000 for taxes (if you use a different percentage, adjust accordingly). You have $700 left in your business account.
  3. $700 is your paycheck you can transfer to your personal account(s). 50% ($350) goes to bills, 30% ($210) goes to savings, and 20% ($140) goes to savings.

You can use this process every time a client pays you or let money build up, then use this process weekly, twice a month, monthly, or whatever schedule you choose.

Example 2 (Steady Paycheck)

You want a $1,000 weekly paycheck before taxes. You received $2,000 this week in your business account and had $500 in expenses.

  1. Pay $500. You have $1,500 left in your business account.
  2. Since you only want to pay yourself $1,000, mentally subtract $500. The $500 stays in your business account for when business is slow and you need it to pay yourself the full $1,000.
  3. Set aside 30% of the $1,000 you want to pay yourself for taxes (if you use a different percentage, adjust accordingly). You have $700 left to work with.
  4. $700 is your paycheck you can transfer to your personal account(s). 50% ($350) goes to bills, 30% ($210) goes to savings, and 20% ($140) goes to savings.

Example 3 (Adjusting for a Slow Week)

You received $1,000 in your business account. You had to pay $500 in expenses. You want to pay yourself $1,000.

  1. Pay the $500 in expenses. You have $500 left from this week’s revenue.
  2. You had $500 extra last week.
  3. $500 from this week plus $500 from last week equals $1,000.
  4. Repeat the steps to set aside taxes and distribute the rest of the $1,000 according to the 50/30/20 rule.

What can you do with extra money in your business checking account?

If you arrange your finances to give yourself a steady paycheck, you may find yourself with extra money in your business checking account when business is good and you keep building up reserves. You have a couple of options.

  • Open a business savings account. This lets you earn interest on your reserves while still keeping them separate from your personal budget.
  • Pay yourself a bonus. Choose a bonus amount and then follow the same steps as Example 2.

Reminder: Your actual taxable income is based on your business profit for the year. The concept of “paychecks” in this post is just for budgeting and easy math. Taking money as a “paycheck” or leaving it in your business accounts doesn’t change whether you pay taxes on it or when you pay taxes on it.

Conclusion

You can still use the 50/30/20 budgeting rule if you’re self-employed. You just need to make a few adjustments so you’re budgeting on your paycheck instead of your business income or income before taxes.

Sponsored Links:

Leave a Comment

All comments are public and may be posted with or without edits. Don't include any sensitive information. This is not the IRS — I did not send you a letter or hold your refund.

Advertisements
Ask a Tax Expert Now
Ask a Tax Expert Now
Talk to a Tax expert online now. Describe your issue. Chat 1:1 with an expert. Save time and money.
Talk to a Tax expert online now. Describe your issue. Chat 1:1 with an expert. Save time and money. Show Less
Shop for Instacart
Shop for Instacart
Set your hours and earn on your own terms. Sign up today.
Set your hours and earn on your own terms. Sign up today. Show Less
Create Your LLC in Minutes
Create Your LLC in Minutes
Form your LLC in minutes starting at $49. Fast and simple tools to help you figure out each step of the process.
Form your LLC in minutes starting at $49. Fast and simple tools to help you figure out each step of the process. Show Less
File Your Tax Return
File Your Tax Return
Start for free.
Start for free. Show Less