Self-employed individuals, freelancers, and commissioned workers all struggle with one area of their finances: managing a variable income. When you don’t know how much money you are going to make this month or this year, it is tough to start saving. I know this all too well as a self-employed financial planner.
Having a variable income creates a type of stress that salaried workers don’t have to face. The feeling of the unknown future leaves you stuck in the present, unsure of which step to take next. How can you risk putting money into a long-term investment if you might need that money to pay the bills a few months from now? By taking small steps in the right direction, you will slowly regain the confidence to invest in your future self.
Pay yourself a salary. To start, look back over the past 12 months of income. The month with the least amount of income is now your baseline. You will pay yourself this amount on the first of each month as your “salary”. Don’t forget to set aside money for self-employment taxes. Hopefully this new salary is enough to cover your necessary living expenses. Any month with income above this level can be put toward your financial stability.
Track your spending. Not only do you need to track 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 small, you may be able to handle the tracking on your own. Consider hiring a bookkeeper if your business finances grow more complex.
You need to track your personal spending as well. It’s the only way you know how much money you have available to invest. The alternative is to automate your monthly investment contributions and spend what is left over.
Keep a larger emergency fund. A variable income brings additional risk into your financial life. Without a sizeable savings account, a dry spell in income can force you into credit card debt. Build up your emergency fund to six months of business and personal expenses, or more. A salaried employee can get away with a smaller emergency fund, as their income is more predictable.
Live off of last month’s income. The online budgeting tool You Need A Budget has a philosophy that I love. They call it “Age Your Money”. This rule only allows you to spend up to the amount you made last month. If you are paying yourself a baseline salary, hopefully this won’t be an issue. But in a lower income month, temporarily restricting your spending keeps you afloat until higher income resumes.
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 see money left over. Use this money to fund your financial goals. If you have any high interest debt, pay it off. After that, start maxing out your retirement accounts--Solo 401(k), Roth IRA, HSA, and more.