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SELF-EMPLOYED individuals, freelancers and commissioned workers all struggle with a key area of their finances: managing a variable income. When you don’t know how much you’ll make this month or this year, it’s tough to start saving. I know this all too well as a self-employed financial planner.
The uncertainty can leave you stuck, unsure which steps to take next. How can you risk putting money into long-term investments if you might need it to pay the bills a few months from now? My advice: Take these five steps—and you’ll slowly gain the confidence to invest in your future self:
1. Pay yourself a salary. Look back at the income you earned over the past 12 months. Use the month with the least amount of income as your baseline. You’ll pay yourself this sum on the first day of each month as your “salary.” Don’t forget to set aside money for self-employment taxes. With any luck, this new salary will be enough to cover your fixed living expenses. Thereafter, if you have a month with income above this level, you can put the extra money toward your financial future.
2. Track your spending. You need to track not only your personal spending, but also your business spending. Self-employed workers have a bad habit of mixing business and personal expenses. If your business expenses are modest, you might track spending on your own. But if the finances grow more complex, consider hiring a bookkeeper.
You also need to track your personal spending, so you know how much you have available to invest. The alternative: Automate your monthly investment contributions and then force yourself to live on whatever is left.
3. Keep a larger emergency fund. A variable income brings additional risk to your financial life. Without a sizable savings account, a dry spell for business income could force you into credit card debt. Build up your emergency fund to six months of business and personal expenses, and perhaps more. Salaried employees, by contrast, can get away with a smaller emergency fund, because their income is more predictable.
4. Live off last month’s income. The online budgeting tool YouNeedABudget.com has a philosophy I love: It’s called “age your money.” This rule limits your spending to the amount you made last month. If you’re paying yourself a baseline salary, hopefully this won’t be an issue. But if you get hit with a lower income month, temporarily restricting your spending will keep you afloat until more income comes along.
5. Invest the rest. Review your baseline income and monthly spending on a quarterly basis. Since your baseline salary was the least you earned over the previous 12 months, you should have money left over. If you have any high-interest debt, pay it off. After that, start maxing out your tax-favored accounts, including a solo 401(k), Roth IRA and Health Savings Account.
Ross Menke is a Certified Financial Planner. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross’s previous articles include Spending Happily, Picture This and Rewriting the Script. Follow Ross on Twitter @RossVMenke.
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Great advice on how to flatten self-employment income variability. I would also add looking at your tax deferred options. One of the things that surprised me was how much more I could save in a tax deferred account while self-employed.
I have a method for how I manage my self-employed cash flow:
Expenses – try and keep those low. I laugh when people tell me ‘just expense it.’ I’ve got to make money in order to ‘expense it’ and if I minimize those expenses, then there is more cash flow for other things I might need or want.
Taxes – ~45-50% of every self-employed dollar I make is set aside for taxes (self-employment is 15.3% right off the bat – then depending on how much you net from there, your federal tax rate kicks in and then state income taxes – if you can, build a spreadsheet which iterates these numbers as you track your income and expenses – you will also be amazed at how your taxes fluctuate based on how much you put into tax deferred retirement accounts)
Savings – after setting aside the dollars for expenses and taxes, I pay the remainder as salary to me, while keeping an ’emergency’ amount in my business checking account to manage the floats on expenses or to have the ability to purchase a needed item or travel, etc. That salary is then divided by half with one half going to an after tax savings account and then the rest used for my personal living expenses.
The above can be done in order based on your self-employment income number.