(By J.D. Roth)
“Every month as you earn income, receive it (and leave it) in your business account. This is where you accumulate your cash. Because it’s in a high-yield savings account, it earns interest as it waits for you to use it. From this money, pay yourself as if you were an employee. Your monthly salary is whatever you calculated as your monthly budget, your minimum monthly income from the past twelve months.“
Bloggers aren’t the only folks who struggle with the fluctuating incomes, of course. Many freelancers face the same issue, as do those whose pay is tied to commission. Creating a budget when your income fluctuates can be a frustrating experience. I’m sure that each of us finds our own ways to cope. Today, I want to share the method that I’ve developed.
Most articles I’ve read on this subject suggest basing your budget on your average monthly income from the past twelve (or six or three) months, but I don’t recommend that unless your income has wild swings — $12,000 one month and $0 the next.
As the past 18 months have demonstrated, incomes can and do decline. A prolonged decline wreaks havoc with the “average income” budgeting method. When I project my cash flow, I base it on my minimum monthly income from the past twelve months. Using my minimum monthly income instead of my average monthly income gives me a safety buffer. And when you have an irregular income, a safety buffer is vital.
Note: If your income is variable, but you know that you’ll always make at least $X,XXX, then it makes sense to base your budget on $X,XXX. Anything you earn above this amount is gravy.
A hypothetical example
For the sake of illustration, I’ve constructed a hypothetical example of the monthly income a freelance designer might have earned in 2008. View hypothetical 2008 income chart.
The “actual” column shows the designer’s actual income by month. The “average” column shows the average for the entire year. Using the standard advice, this designer would then construct her 2009 budget based on the average monthly income from 2008. Her 2009 budget would be $3891.67 per month. But what if her income declined in 2009, as happened to many freelancers? View hypothetical 2009 income chart.
In this instance, the designer’s average monthly income for 2009 was $3600, or nearly $300 less than she budgeted. And because her first few months were fantastic, she might have been tempted to splurge beyond her budget. That would have been a mistake. If, instead, she had constructed a budget based on her lowest month in 2008, she would have done okay. View irregular income chart.
Now, obviously I’ve fabricated these numbers out of thin air in order to make a point. But based on recent conversations with a variety of people who earn irregular income (bloggers, designers, contractors, entrepreneurs), many folks faced this sort of situation in 2009. Their incomes dropped, and their budgets weren’t ready to cope.
Building a budget
Projecting cash flow is only part of the battle. After finding a basis for my budget, I followed a simple system to manage my money. I recommend using two different bank accounts to make this work:
The first is your “business” account (without quotes for those of you who actually own businesses), which is where you deposit all of your income. My business account is a high-yield savings account with ING Direct (You might use FNBO Direct or some other bank. Just choose a savings account with a high interest rate.)
The second is your personal account, and it’s from this that you’ll pay your ongoing expenses. There’s no need to open a new account if you already have one that will work. I just use my existing credit union checking account.
Every month as you earn income, receive it (and leave it) in your business account. This is where you accumulate your cash. Because it’s in a high-yield savings account, it earns interest as it waits for you to use it. From this money, pay yourself as if you were an employee. Your monthly salary is whatever you calculated as your monthly budget, your minimum monthly income from the past twelve months.
At “I’ve Paid for This Twice Already,” PT writes that “the key to budgeting with irregular income [is to] make it mimic regular income as much as possible.” I agree. On a set date each month, write yourself a paycheck. Leave the rest of the money in your business account. (Here’s more on the “virtual employer” concept.) At the end of each year, three things happen.
First, you reset your salary. Based on the previous year’s numbers, your income might increase — or it might decrease.
Next, you use the “extra” money you’ve been accumulating in your business account to pay taxes. I could write an entire article on budgeting for taxes with an irregular income, but for now let’s just note that it’s very important that you remember to account for them, especially if nobody else is withholding them from your paycheck.
Finally, if you have anything left after paying taxes, you pull this money out of the business account as personal income. It is, in essence, a year-end bonus. You can use it for whatever you see fit: debt reduction, long-term savings, a Mini Cooper.
In first glance, this system may seem complex. It’s not. It’s actually very easy. To summarise: I base my budget on my lowest monthly income from the previous year. When money comes in, it sits in a bank account. Each month, I write myself a paycheck based on my budgeted amount. The rest of the money is saved to pay taxes. If there’s any left over at the end of the year, I get a bonus.
Note: The first year is difficult. You generally don’t have the ability to base your budget on averages or on the lowest income from the last twelve months. (I was able to do this because I’d been earning money before I quit to blog full-time.) Instead, you’ll have to use some other method to project your income. Whatever you do, remember: It’s easier to deal with a budget surplus than it is to deal with a budget deficit!
Tips and tricks
There are few other things that make living with an irregular income go more smoothly. The following tips and tricks build on the core personal finance
skills I discuss often at Get Rich Slowly:
Establish a foundation of thrift. The number one thing that helped me cope with an irregular income was adopting a lifestyle of thrift. I took steps to slash my spending. I decreased my recurring monthly expenses. I found cheap or free alternatives to the things I used to spend money on (Hulu instead of cable television, the public library instead of the bookstore, etc.).
Prioritize spending. Many of the budgeting guides I’ve read suggest creating a list of prioritised expenses. Financial guru Dave Ramsey, for example, recommends listing all of your expenses in order of importance. (“Importance, not urgency,” he says.) When you get paid, start at the top of the list and work own. This is an excellent method for those who are struggling to make ends meet.
Build a buffer of savings. Before I quit my “real” job to become a full-time blogger, I began to set aside a large sum of money as an emergency fund. I figured that if my income dropped below the minimum I needed to get by, I could tap the emergency fund to provide supplemental cash. With luck, I’d be able to ride out any rocky storms. (I’ve been fortunate to not have to do this.) When you have an irregular income, the bigger your emergency savings, the better.
Tap your business account only as needed. As money accumulates in your business account, you’ll be tempted to draw from this pool for fun and games. Don’t do it. Remind yourself that this money is for taxes — and for your monthly salary.
Resist lifestyle inflation — especially during the good months. Lynnae at Being Frugal writes: “One of the biggest downfalls of having a variable income is the tendency to overspend on good months. Believe me, I understand. Your money is stretched to the limits in the lean months, so on a good month, you’re empted to spend a little bit more on fun stuff. But when the next lean month comes, there’s no extra money left to help ride it out.”
If possible, live off just one income. If you have an irregular income but you have a partner who makes steady money, explore the possibility of living solely on her income. Use your partner’s money to meet the necessities, and use yours to pay for savings and extras. This isn’t an option for most people, but if you can manage it, it’s a great way to budget.
Do you have irregular income? If so, how do you budget for the fluctuations? Can you offer any additional tips? I’m especially interested in tips for those who are just getting started with self-employment or variable incomes.
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