(5 minute read)
Hi there accounting fans! Let’s learn how to pay yourself as a business owner!
I’ve written about paying yourself in a previous article, but this guide will provide detailed steps on how to do just that!
So you’ve just started a business! Congratulations! Welcome to the world of entrepreneurship and/or self employment! Running a business is never easy. But with the right foundations, you can build your business for success! Let’s talk about how you can pay yourself from the business.
Why it’s important to pay yourself
Running a business means having to worry about sales, marketing, product development, operations AND finances! It’s no wonder business owners have little time to think about themselves. In my experience with my clients (and myself), I often find that as a business owner, paying yourself is the most difficult thing to do because you’re worrying about the following:
- What if I don’t have enough money to pay my operating expenses?
- I don’t think I have enough money set aside for taxes/GST!
All valid worries, and we’ll talk about how to eliminate them later in this guide.
Please note that this guide ONLY works if you have set up separate business accounts for your business.
For now, remember that your business is YOUR vehicle towards financial success. If you don’t start paying yourself from your business, what’s the point of running a business? You might as well be running a charity! Life is hard enough as a business owner. If you restrict yourself from taking money from the business, you place more burden upon yourself and your family. So pay yourself using these simple steps (which I call the Sam Harith method for self payment!):
Pay yourself step #1: Expenses!
If you’ve been running your business for a few months now (3 to 6 months) you have a good idea of what your monthly expenses look like. If you don’t know what your monthly spend is like, you need to talk to your accountant to figure out what this is. As a business owner you should be keeping track of your business spending. Use an accounting software! Use a spreadsheet if you’re really cheap! But please, you MUST keep track of your spending!
Note that as your sales figure grows, this figure may increase. This is true for manufacturing, retail and hospitality businesses which have variable costs. Not so much for service based businesses who’s costs are mostly fixed. You will need to constantly review your monthly expenditure to get a good idea of what your average monthly spend is. A good rule of thumb is to take the monthly expenses of the last 3 months divided by 3 to find the average.
Set your expenses baseline
This is important. Once you’ve established what your average monthly spend is, you need to set an expenses baseline. As a general rule of thumb, your monthly expense baseline should be:
Monthly expense baseline = Average Monthly Expense X 1.5
This means that your expense baseline is your average monthly spend multiplied by 1 and a half times. This is the bare minimum you must be having in your business spending account AT ALL TIMES. If you want to be more conservative, you can multiply it by 2. But 1.5 should provide enough cover and wiggle room for you.
e.g.: Tyrone runs an employment advocacy service and each month, he spends about $2,000 on subscriptions to legal databases, law podcasts and travelling around the country for court appointments and client meetings. His monthly expenses baseline is $2,000 X 1.5 = $3,000. This means at any one time, Tyrone should not allow his bank balance to dip below $3,000. This is to keep his business operational and flowing.
Pay yourself step #2: Taxes!
Yay! Taxes! Everyone loves paying taxes!
But seriously, taxes are important. Regardless of how you feel about them, you MUST PAY THEM. Before you can pay yourself, you first need to ensure that you have enough money set aside for future taxes. To figure out how much you owe in taxes, you can talk to your accountant. If you don’t have one, or if they are unable/unwilling to give you a tax estimate (honestly, get a new accountant who will do that for you!) you can use this estimate:
Estimate your taxes for the financial year
You need to work out how much profit you have made so far in the financial year (this is the same as your tax year).
Once you’ve established your profit so far, take that amount and multiply it by your tax rate. Unsure what your tax rate is? You should take a look at your local tax department’s website to figure out where you stand in term of tax rates! If you are running a company, tax rates are flat. (in NZ it is 28% as of August 2021). If you are a sole trader, you may be taxed at the individual scale rate.
Don’t like calculating taxes? That’s ok, that’s why I still have a job! Let’s keep it simple then – take 20% to 30% (depending on how high your local tax rates are) of the profit you’ve made so far in the year and make sure you have that much money (or more) in your tax savings account!
E.g: Riley runs an auto shop and she’s worked out her profit so far in the 2022 tax year to be $30,000 in September 2021. As a rough estimate, she takes a tax rate of 25% and multiplies it by $30,000 to get a tax estimate of $7,500 ($30,000 X 25%). She checks her tax savings account and sees that she only has $6,000 in her tax savings account. She transfers an additional $1,500 from her daily spending account into her tax savings account to make sure she has enough taxes put aside for the year.
Estimating your GST for the period
If you are paying GST/VAT/SST, you will want to make sure you have enough set aside for your next GST payment! To do this, take a look at your profit for the GST period so far. To keep it simple, calculate your profit so far for the period* you are in and multiply it by the GST rate (15% for NZ).
E.g. Riley is looking to pay herself on 15 September 2021. She pays GST bi-monthly. This is in her 1 August to 30 September GST period. She uses an accounting software to figure out her profit from 1 August to 15 September 2021. She has profit of $5,000 so far. This is GST of $750 (15% of $5,000) to pay for the period. She checks her GST savings account and there is only $500 in it. She transfers another $250 from her daily spending account to make sure she has enough to cover the period so far.
*note that with accounting software like Xero and MYOB – you can generate GST reports that show you exactly how much GST you have incurred for the period so far. So you can use these reports instead of calculating GST estimates based on profit if you use accounting software.
Pay yourself step #3: Balances!
Got enough money to cover monthly expenses? CHECK!
Got enough money to cover taxes and GST? CHECK!
Okay then if all the bank account balances check out, it’s time to pay yourself with any money left over! You will pay yourself from the daily spending account. You will want to pay yourself the lower of:
- Your market rate OR
- The remaining amount of cash in your daily spending account (less your monthly baseline expenses)
What’s your market rate?
Your market rate is the amount of money that you would normally get if you were working as an employee in a similar industry. You should know this better than anyone else, it is YOUR INDUSTRY after all.
e.g: Yara is a self employed book keeper. She is looking to pay herself. She’s checked that she has enough balances to cover her monthly baseline expenses and her taxes/GSTs. Prior to starting her own business, Yara worked as a book keeper for $23/hour for a local construction firm. This worked out to be about $500 a week after taxes – this is her market rate. Her daily spending account has $1,000 left in it (after taking away monthly baseline expenses). So she pays herself the lower of the two, which is $500 out of her daily spending account. She transfers this amount into her personal spending account.
How often should you pay yourself?
As a rule of thumb – I would go for once every week or every two weeks. Small amounts in higher frequencies is better than a lump sum say every one or two months.
Every time you pay yourself you MUST go through these three steps outlined above. The more often you pay yourself, the faster you train your mind to instinctively know how much money you have left to spend. This also has the added effect of training you to be more financially savvy.
I also want to emphasise here that you DON’T pay taxes on any amount you pay yourself. You have already put aside taxes for this in #step 2 above!
Paying yourself when the business grows
As the business grows and you start taking on employees, you may want to reconsider how you pay yourself. Instead of taking drawings, you may even want to pay yourself a fixed salary (with PAYE deducted). Many businesses that operate as companies hire their owners as employees of the firm. However this is more applicable to businesses with an employee base of 5+ people AND/OR are raking in sales of $1,000,000 plus a year. You can always top up your salary by paying yourself dividends. But we’ll save that discussion for a later date.
Bonus: pay yourself as a barefoot investor!
If you’ve followed my blog for a while, you will know I’m a huge fan of Scott Pape’s book ‘The Barefoot Investor’. I credit Scott’s book with inspiring me to start this blog! Part of the Barefoot strategy is to set up ‘buckets’ to put your salary/wages into. For all it’s beauty and simplicity, The Barefoot investor doesn’t talk about how self employed business owners pay into their buckets!
Using the steps outlined above, now you too as a self employed business owner can draw a (mostly) predictable income into your personal daily expenses account. You can then use this amount to apportion out into your splurge, smile and fire extinguisher accounts with each payment.
e.g.: After completing steps #1 to #3 above, Wong decides to pay himself $750 for this week. He transfers $750 into his personal daily expenses account. From here, he transfers 10% of $750 ($75) into his Smile and Splurge accounts. He then transfers another 20% ($150) into his Fire Extinguisher account – for use for mortgage repayments and/or long term investments.
Wait! Before you pay yourself!
If you follow these steps, your business should always have enough money to cover expenses, taxes and your personal lifestyle. Assuming that you are generating enough sales that is.
Self employment is unpredictable. Income varies from month to month. Some months are good, some months are bad. If you don’t have enough money to cover your taxes and baseline expenses, you should not be paying yourself. It is one of the hard truths of entrepreneurship. Especially at the start, before your business becomes better established.
NEVER EVER setup automatic payments to your personal account from your business account!!! This is how you run up unnecessary business debt and end up paying the bank more interest in the long run. Business is unpredictable and if you have a set amount going out every month, you may be dipping into your monthly baseline amounts without even realising it!
Always, ALWAYS perform steps #1 to #3 EVERYTIME you pay yourself. NEVER AUTOMATE YOUR PAYMENTS TO YOURSELF. I cannot stress this enough!
Expenses –> Taxes –> Balances!
Ok, now that I’ve made that clear, go ahead and pay yourself! You deserve it!