Self-employment is on the rise and independent workers now make up 31% of the private workforce. While being your own boss and having a flexible schedule is appealing, having unpredictable income can make reaching financial goals extremely challenging.
Whether you run your own business, freelance, or have a side hustle, it is still possible to budget and plan your financial life–just like you would if you had a steady paycheck.
For clients that are self-employed or have a traditional job with variable pay (like sales), I recommend a Variable Income Fund (VIF).
This is one of the most effective tactics for riding that income rollercoaster and you can create one for yourself in just five steps.
1) Separate your business and personal expenses.
Managing your own finances is already complicated enough for most people. Combining your business and personal expenses adds another layer of complexity that makes it much more difficult to understand what’s going on.
For example, let’s say you racked up a little credit card debt last month. Was it because your business had some extra expenses or did you just spend too much money on dinner and drinks with friends?
First things first, you need to set up separate bank accounts for your business and personal life so you can identify and troubleshoot issues as they arise.
2) Figure out what your monthly expenses are.
Your monthly expenses are the sum of your fixed costs, goals, and what I like to call Choice Spending.
Fixed Costs:These are your bills that recur monthly and are roughly the same amount each month. Some examples are rent, health insurance, and your cell phone.
Goals:Determine how much you want to set aside each month for goals like saving for retirement, travel, or establishing an emergency fund.
Choice Spending:Give yourself a budget for miscellaneous spending like food, household items, and entertainment.
My clients categorize their expenses so they know exactly how much they spend on each of these but if you’re not sure just look at bank and credit card statements to see what you’ve spent in previous months.
3) Calculate your Average Monthly Take-Home Pay for the past 12 months.
Since you don’t make the same amount of money each month, you have to figure out what your Average Monthly Take-Home Pay equals.
If you’re confident you will make at least as much as you made last year, the easiest way to do this is to add up the total amount of money you brought in last year, subtract the amount you paid in taxes, and divide that number by 12.
This number is your Average Monthly Take-Home Pay and the number you will use when planning your financial life.
4) Make sure you’re living within your means.
Are your monthly expenses higher than your Average Monthly Take-Home Pay? If so, then you are spending more than you earn and living above your means.
This is a common occurrence for workers with variable income. Without the constraints of a traditional salary, it’s easy to be overly optimistic and predict you’ll make a lot more than you actually wind up making.
This is also a big reason why many independent workers say it’s difficult to save for goals. For example, only16% of independent workers are saving for retirement.
Cutting expenses is usually the easiest way to resolve this issue, or you may realize that you need to earn more income to keep up with your lifestyle.
5) Open a Variable Income Fund.
Now that you know what your current financial situation looks like you can put this knowledge to work.
Remember your Average Monthly Take-Home Pay number? That’s how much you are going to pay yourself each month, regardless of how much you actually earn. And a Variable Income Fund is going to make this all possible.
Your Variable Income Fund should be a separate savings account funded with at least a month’s worth of Average Monthly Take-Home Pay.
To put this in perspective, let’s say your Average Monthly Take-Home Pay is $3,000.
On months where you earn more than $3,000 you should put any extra earnings in your Variable Income Fund. So if you earn $4,000 next month after setting aside money for taxes, pay yourself $3,000 and put that extra $1,000 in your VIF.
On months where you earn less than $3,000, use your VIF to pay yourself. Let’s say you only earn $1,500 the following month after setting aside money for taxes. Then pay yourself that $1,500 plus $1,500 from your VIF. This will allow you to live your normal life spending $3,000 per month even though you only brought in half that amount.
What To Do If Your Income Goes Up Or Down Drastically
If your VIF balance gets too high or too low, then it’s time to re-evaluate your Average Monthly Take-Home Pay.
If your balance gets significantly higher, then that means your income has gone up. If your balance gets depleted, it’s because you are earning less than you have historically. At that point you should revisit step 3 and recalculate your Average Monthly Take-Home Pay.
Following this strategy will allow you to consistently pay yourself the same amount of money each month regardless of how much you actually earn. This consistency makes it easier to save for goals, stick to a budget, and plan for your future.
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