Death and taxes. You know the saying. Well, I’m here to warn you that, if you’re not careful when you make the transition to writing full-time (or any other form of self-employment), one might quickly lead to the other. Figuratively speaking, of course.
Here’s what I mean. When you’re working for a company or the government, Uncle Sam and your state normally take their cut right off the top before you get your paycheck. Sure, you have to juggle standard deductions and some other stuff, but the bottom line is that most or all of what you owe gets vacuumed up first.
Not so with your book royalties, especially in what I’ll term your “breakout year”, when you go from maybe making a little to really making a lot like I did in 2011. I’ll give you a little bit of advice that sounds obvious in hindsight, but that I wish I would have had someone beat into my skull:
Find a good tax consultant who has experience with small businesses and the self-employed, and have them put a tax strategy together in the first calendar quarter when you’re paid royalties of more than a couple thousand dollars.
Ironically, it is much more important to do this right away if your royalties suddenly zoom upward.
Why? Because you will find an extremely unpleasant surprise waiting for you come tax time. Yes, you made a load of moolah, and you probably went a little gonzo spending it. “Hey, but I’ve set aside enough for taxes. No biggie!”
That’s where we get to what nature photographer John Shaw once said is Rule of Life #1: Don’t be dumb.
Remember that the retailer or distributor (Amazon, B&N, etc.) just forks over your money. They do not withhold any taxes. Zip. You’re responsible for figuring all that stuff out on your own.
In addition to federal and state or other local taxes, you’re also most likely going to be in for the good ol’ self-employment tax, which can add another 15.3% to your tax burden (with all the attendant bazillion variables that affect the exact amount and percentage that you would actually have to pay). This is a chunk of money that essentially covers your cut for Social Security and Medicare. You have to pay this as an employee of a regular company or the government, but it comes as a surprise to a lot of people who are just starting out in the self-employed realm because, like regular taxes, these deductions were taken off the top by your company before you got your paycheck.
Another factor is retirement. You’re responsible for that now. Yeah, you. There’s no company annuity, no retirement office, nobody looking out for your future but you.
Now, the good news here is that if you set up something like an LLC or other qualifying business, you can establish an SEP-IRA, which is a great vehicle tax-wise. Similar in many ways to a 401k, the money you put into it can be deducted from your gross income, and the interest grows tax-free. So check with your tax consultant to see if this is a good option for you.
And that brings me to the last item to beware of: pulling out your retirement funds. There are going to be cases when you’ll want to cash in your funds. Just make sure you get a tax consultant to give you a projection of your tax liability when you do. With many funds, if you withdraw before a certain age you’ll be hit with a large (10% seems to be common) penalty, on top of the income tax you’ll owe. If you’re pulling out a lot of money, it will likely push you into a higher tax bracket than normal. That can add up quickly, and that’s not a surprise you want to have come tax time.
Another thing about the higher tax bracket: if your royalties come flooding in, be prepared to pay more in taxes than you think, because a ton of new money could easily push you into a higher tax bracket.
Again, I cannot emphasize enough the importance of ongoing dialogue between yourself and your tax consultant. I would touch base with him or her every quarter. Why? Because, unlike a typical salaried job, your income is likely going to vary a lot (sometimes by as much as 400%, possibly more) from month to month, and your tax burden, which you’ll typically pay on a quarterly basis, is going to become a moving target. Your tax consultant can help you make sure that you’re withholding close to the right amount as the year progresses, so when the following April comes you’re not going to be slammed with an ugly surprise.