Tax Savings Accounts: A Case Study

Want to see the inner workings of a tax-savings account? Look no further!

What is a Tax Savings Account?

One of the first things we often suggest to clients when we begin our working relationship is to open a tax savings account. It’s a simple concept that revolves around setting aside a percentage of all revenue each month. 

This portion of revenue is then transferred to a separate tax savings account each month, set aside for only one purpose: To pay estimated quarterly taxes & year-end tax payments. 

This is a concept that has roots throughout the financial world, but the most impactful explanation of this concept is Profit First, written by Mike Michalowicz. Michalowicz dives deeper into setting up multiple accounts under the same concept, (it’s a must read), but in this case study, we’ll stick with just the tax savings account. 

What does a tax savings account do? It eliminates tax-time stress and provides a safety net to cover tax payments that are higher than expected, while at the same time providing a bonus or additional savings to owners when tax payments are lower than expected.

Imagine never needing to dip into personal funds to pay your personal or business taxes. That’s the beauty of a tax account. 

Tax Savings Account: Our Method

To prove the importance, even the necessity of a tax savings account, we’re providing a case study to show how this account can work as well as how it can turn upside down the stress and cash flow strain that tax season can bring.

To make this even more interesting & transparent, this case study revolves around our own tax savings account here at Navigator Bookkeeping. 

First, the basics. Our tax savings account is set-up in QuickBooks Checking, inside of their envelopes feature. (If you haven’t checked out QuickBooks Checking, you should, 1% interest is impossible to find in other checking accounts). 

The tax savings account is set up at 14%, meaning that 14% of all revenue is sent to the tax savings account each month. We usually recommend saving 12-15% of revenue for taxes, depending on the risk tolerance of the business owner, as well as profit margins.

There are a few additional ways to calculate this percentage for low profit margin/high revenue businesses or for businesses with a high percentage of expenses spent on cost of goods, or payroll (see the bottom of this article for examples of these “tweaks”.)

You may wonder how the 14% was decided upon for the tax savings account. It is not a percentage that is set in stone, but was chosen after tweaking done from years of using a tax savings account. Previous years or portions of years we had used 20% resulting in too much saved to the tax savings account (impeding cash flow), and 12%, resulting in slightly too little being saved (leading to a low balance in the tax savings account after tax payments were made).

For our company, 14% has been the sweet spot, but your company may have a different percentage that works. The beautiful piece of the concept is that it is flexible and can be changed throughout the year. 

Throughout 2021 the 14% was sent twice a month to the tax savings account. (Profit First recommends the 10th and 25th of each month, many of our clients will only transfer once a month, in our opinion, either is fine as long as the method is consistent). The 14% was calculated simply by multiplying cash received for each period of time by .14. 

As the year progressed and estimated tax payments were made we were able to do some simple projections, ensuring that with our current levels of revenue, enough would be saved to cover estimated tax payments. 

By the end of 2021 our revenue and profitability had increased, with our profit for the year doubling. Since estimated tax payments are usually based on the previous year’s tax liability, and tax liability is based mainly on year-end profit, this meant that our estimated tax payments likely would be quite short of what we would owe.

If we didn’t have a tax savings account, this is where we would begin stressing, realizing that higher profits, though exciting, also mean exponentially more expensive tax bills. 

The Results

After sending in all of our documents for tax filing & meeting with our tax filer, we were given the “big reveal”, our total tax due at the end of the year. To give concrete numbers, by the end of 2021, after estimated taxes had been paid for all four quarters in the year, our tax savings account had a balance of around $12,500.

Our total tax bill ended up being right around $5,000, with a further $3,000 needed for the first quarter payment. This totals out to $8,000 due 4/18 since 1st quarter and 2021 year end taxes are due the same day for most businesses, including ours.

(Our tax liability would’ve been closer to $12,000 had it not been for our second child born in 2021. Notice that our tax account could’ve covered this much higher balance, even without the tax savings from the Child Tax Credit & Stimulus Check from our second child).

 Since this was the case in February, when we found out tax balances, this gave us an additional 2.5 months to continue contributing to the tax savings account, and save enough for the tax savings account to cover the 1st quarter estimated tax payment as well as the year end payment for 2021. 

After those additional savings from our second child (who says children are expensive?), we owed $8,000 total for 2021 & 1st quarter estimates, all due 4/18. The same period ended with around $12,500 in our tax savings account.

After liabilities were paid, this allowed us to leave enough in the account to cover tax filing fees, seed the account for the second quarter payment (due in June), and still take a substantial draw from the excess savings. 

To summarize, our tax savings account not only covered our estimated payments for 2021, our year-end payment for 2021, and our first 2022 payment, it also covered tax filing fees and provided a bonus at the end of the tax year, all without using any personal funds. Not bad.

This is one case study of how a tax savings account allows a business to pay its owner’s taxes. Every year during tax season, we see this happen time and time again with our clients who have tax savings accounts set-up.

The beauty of the system is both that it’s flexible and it works for very small and very large businesses. We’ve seen it work equally well for a business that brings in $50,000 in annual revenue and a business that brings in $5,000,000 in annual revenue. 

How To Implement Your Tax Savings Account

What’s holding you back from starting a tax savings account? Simply follow these three steps to get started. 

  1. Open a separate checking or savings account. If you can open an account that will gain some interest for you, that’s a bonus.
  2. Determine what percentage of revenue should be saved each month. Usually this should be between 12-15% of monthly revenue.
  3. Transfer your decided upon percentage of revenue each month (or twice a month) to your tax account and never worry about scrambling to find  money for tax payments again. 

Below are a few tweaks to the system you can make, depending on your business needs.

  1. Some business owners prefer to set aside a percentage of profit, instead of revenue. This technically can get you closer to the amount of tax you’ll owe, as most tax is based on the annual profit of the business. If you decide to go this route, follow the system in the same steps outlined above, but instead multiply your monthly profit by 35% and transfer. This can be a helpful “check-in” to do quarterly, even if you’re using a percentage of revenue instead, especially if you have high revenue, but low profit margin. In that scenario, you may set aside too much tax based on revenue, so using profit instead may give you a more accurate number.
  2. If a high percentage (above 20%) of your revenue goes towards Cost of Goods consistently, you may want to instead multiply your decided upon percentage by your “Real Revenue” number. This is a Profit First term that means the same thing as Gross Profit. In this scenario you take your monthly revenue, subtract out your Cost of Goods and then multiply your tax percentage by this number. This will help resolve the issues in the first “tweak” listed above. 

Whatever you decide to do, please reach out if you have questions, or would like assistance implementing this system. It’s a subject we’re passionate about and greatly enjoy discussing!

You can schedule a discovery call below to get your own savings account set up!

If tax-time brings up feelings of angst, despair, and stress for you, this is the strategy to use. A tax savings account allows you to save throughout the year for your estimated taxes & year-end taxes, allowing you to be prepared for any and all owed amounts, as well as any surprises that come up along the way. Watch this quick video to learn how to utilize this very handy tool.

Watch the video below: