How To Save For Tax

How to save for tax

We often welcome new clients to The Real Thiel family that have a few outstanding tax returns to lodge. The first step to being on top of tax is to get everything lodged, and then to pay the ATO everything they’re owed. Clean slate.

When you have a tax bill to pay, this usually triggers the ATO to register you for quarterly PAYG-I (instalments or prepayments you make now towards next year’s tax bill). Read more about that here. So there is usually one year that hurts a little extra because you are paying off the tax return just lodged and pre-paying for the one coming up! But, when we get to next year and lodge, most or all of that bill will be prepaid. You’ll be ahead! 

One approach is just to pay those quarterly activity statements when they appear in myGov. But, a chunk of money once a quarter can still feel like a surprise. Putting a bit aside, a little more regularly, goes a long way.

We recommend that you:

1. Have a bank account specifically for saving for tax and super, and nickname it ‘ATO’s money’ so you aren’t tempted to dip into it
2. Keep good records (summary spreadsheet) throughout the year 
3. Calculate your estimated annual tax bill and check how you are tracking against this regularly
4. Automate saving for tax - set up scheduled transfers from your main account to the ‘ATO’s money’ account each week
5. When the tax bill comes at the end of the year or when the quarterly instalments come up to pay, you will have most, if not all, of the money in the account ready to go.

What do I get taxed on?

To follow along for the next part you need to understand a few key terms:

• ABN (sole trader) Profit
  
  Profit = Income minus Expenses
  
  
• Taxable Income - this is what you get taxed on
  
  Taxable Income = Assessable Income minus Allowable Deductions
  
  
• Assessable Income - this includes the ABN/business profit, as well as earnings from wages, salaries, Trust distributions, net rental income (from investment properties), dividend income… just to name a few!
  
  
• Allowable Deductions - other deductions allowed that aren’t related to the business. This includes things like donations or maybe a uniform or some work from home expenses. 

If you are an individual with employment, then your employer probably looks after the tax stuff for you. On your payslip you will see earnings, PAYG-W being the amount of tax they withheld from your wages, and your net pay which is what you physically received as payment. 

When we get to tax time, your employer would have already told the ATO everything (hopefully) and the information will come through MyGov for you as ‘prefill’. 

If you only have employment earnings as assessable income, then this is all you should get taxed on. Since your employer already put tax aside and paid it to the ATO on your behalf, there shouldn’t be anything else you really need to put aside.

If you have other assessable income, such as profits from sole trader business activities - then you need to put extra tax away yourself, because no one else is looking after this for you. 

How much do you (sole trader) put aside each week?

There are a few schools of thought when it comes to this. Our favourite is example 3.

EXAMPLE 1: ‘20% of income’

$1,000 of income received, put aside $200. 

$500 received, put aside $100. 

This often gets thrown around in the arts as a good way to do it. I think of it as an approach that is better than nothing, but it’s not very accurate. Why is it not my favourite?

• It relies on you remembering to make the transfer to savings each time.
• You don’t actually get taxed on ABN income, you get taxed on ABN profits. 
• The amount (20%) is arbitrary and only works for people in some tax brackets. 
• If you received $90,000, you would have put aside $18,000. If the profit was  $60,000 profit in the business (which is the bit that actually gets taxed) and that was your only taxable income, then you will have a tax bill of about $11,500 (assuming it is FY2021 and you have a HECS debt). You saved too much!
• If you had the same business situation, but also had employment and earned $55,000 from that job, then your total taxable income is $115,000. Your employer put aside $9,300 already, but collectively the total tax bill would be $39,500. So the $18,000 you put aside, plus the $9300 from your employer (total $27300) misses the mark by a fair bit: $39500 - $27300 = $12,200 (the difference you would need to make up yourself  in order to pay your tax bill).

See? Not bad, but not perfect. 

EXAMPLE 2: Based on last year’s bill

Let’s say for the FY2020 tax return you had a total bill of $10,000, you might use that as a base and assume FY2021 will be basically the same. So, you calculate $10,000 / 52 weeks = $192 to auto transfer to savings each week. 

This method relies on the new year being the same or very similar to the previous year. This is only appropriate for some businesses. Ideally you are growing your business so you would  need to put a little more away each year! 

EXAMPLE 3 (MY FAV): based on forecast/and actuals

Case study #1: If you only have sole trader business profits as your taxable income.

In JULY each year:

1. Look at each month from last year.
2. Consider your targets and goals for this year ahead.
3. Figure out your profit intention for the new financial year.
4. Go to this calculator online: https://paycalculator.com.au/
1. Type into ‘annual salary’ the total annual profit you expect for your business
2. Then scroll down to see the amount of tax you will likely have to pay by the end of the year (either through quarterly instalments or in one lump sum later).
   In the example of $60,000 business profit, with a HECS debt, the bill is expected to be $11,487. 
3. Take this annual amount and divide by 52 = $221 per week auto transfer to the ‘ATO’s money’ bank account.

In OCT, after the first quarter of the year is done

1. Add up how much you have saved so far.
   12 weeks x $221 = $2,650. 
2. Look at your actual results for the quarter. Let’s say from 1 July to 30 Sept you have $10,000 of profit. 
3. Extrapolate that out for the full year. One quarter is done, and we need to assume the next three quarters will be similar, so $10,000 x 4 = $40,000 annual estimate.
4. Plug this $40,000 into the calculator. Note the new annual tax estimate = $3,887. 
5. This means $3,887 - $2,650 = $1,237 left to save. 
6. Re calculate how many weeks to go (40) and how much to now save each week.  $1,237 / 40 = $31 per week. 
7. Update the auto savings transfers.

In JAN, after the second quarter is done, we do the same thing, but this time we look at the actual results for half a year. Then multiply them by 2 to get to an annual estimate.

1. At 31 Dec you have now saved $2,650 + $372 = $3,022 for tax.
2. Let’s say your new actual profit for half a year is $50,000 (woohoo - big quarter!).
   $50,000 x 2 = $100,000 profit
3. Plug this $100,000 into the calculator. Note the new annual tax estimate = $31,187. 
4. This means $31,187 - $3,022 = $28,165 left to save. 
5. Re calculate how many weeks to go (26) and how much to now save each week = $28,165 / 26 = $1,083 per week.
   You can see how dramatically the tax bill can change when the business profit moves up or down a lot! It is important to use real numbers and to check and update often. 
6. Update the auto savings transfers accordingly to the ‘ATO’s money’ bank account.

In APRIL (we’re nearly there!) take the actual profit from July to March, divide 9 and multiply by 12, to get to the annual estimate. 

Case study #2: If you have business profits and other income (for example, wages from employment).

Let’s say you have the same business as above, but also earn $40,000 from wages. 

In JULY each year:

1. Go to this calculator online: https://paycalculator.com.au/, type in the $40,000 you know about (re wages), and see how much tax you think your employer will withhold and then pay to the ATO for you.
   = $3,887.

1. Now for the business, look at each month from last year
2. Consider your targets and goals for this year ahead
3. Figure out your profit intention for the new financial year
4. Go to this calculator online: https://paycalculator.com.au/
1. Type into ‘annual salary’ the total annual profit PLUS the $40,000 from wages
2. Next, scroll down to see the total amount of tax you will likely have to pay by the end of the year (either through quarterly instalments or in one lump sum later)
   In the example of $60,000 business profit, plus $40,000 wages = $100,000 into the calculator, with a HECS debt, the bill is expected to be $31,187. 

                3. Take this amount, and minus away the bit that the employer is paying for you:
                    $31,187 - $3,887 = $27,300 

                4. Take this annual amount and divide by 52 = $525 per week auto transfer to                                the ‘ATO’s money’ bank account. This is the amount you need to save from                                    your business. 

In OCT, after the first quarter of the year is done

1. Add up how much you have saved so far.
   12 weeks x $525 = $6,300. 
2. Look at your actual results for the quarter. Let’s say from 1 July to 30 Sept you have $10,000 of profit. 
3. Extrapolate that out for the full year. One quarter is done, and we need to assume the next three quarters will be similar, so $10,000 x 4 = $40,000 annual estimate.
4. Punch this $40,000 (plus the $40,000 from wages = $80,000) into the calculator. Note the new annual tax estimate = $20,987.

1. This means $20,987 - $6,300 = $14,687 left to save. 
2. Re calculate how many weeks to go (40) and how much to now save each week = $14,687 / 40 = $367 per week. 
3. Update the auto savings transfers.

In JAN, after the second quarter is done, we do the same thing, but this time we look at the actual results for half a year. Then multiply them by 2 to get to an annual estimate. 

In APRIL (we’re nearly there!) take the actual profit from July to March, divide by 9 and multiply by 12, to get to the annual estimate. 

You get the idea, and if you don’t - time to book a consultation! OR check out our VIDEO VERSION of How To Save For Tax here.

REMEMBER - no one knows the exact amount you will need to pay (not even me) until we actually prepare and lodge your return, so the goal is just to estimate and put something realistic aside in preparation. I have led you to water - NOW DRINK HORSEY, DRINK!