How To Budget For An Irregular Income
The working world seems to be separated into two groups: the employed and the self-employed. For those of us who are newly self-employed, the biggest question is probably how to budget for an unreliable income. When you're employed, it's effortless: you receive X amount of dollars per month, and that's what you use to build your budget on.
However, as a freelancer you will have fat years and lean years. You will hit both the highs and slumps in income, so you need to ensure you aren't caught off guard when they roll around. (Learn the pros and cons before you bid adieu to sales meetings and power suits forever. For more, see Be Your Own Boss By Freelancing.)
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Work Backwards to Create a Budget
Since you can't rely on your income, you have to control your expenses and save the rest for the months you won't have any work. So instead of relying on a set amount of income each month and creating a budget from that, you have to look at your expenses first to create a budget.
Write down every essential expense: rent, utilities, laundry, internet, phone, food, medical, gas and car-related expenses (parking, car registration, etc.). Then, designate another reasonable amount as a buffer ($200 for example). Try the budget out for a couple of months to make sure it is doable, and adjust accordingly.
Keep a larger-than-normal emergency fund so that you won't dip into your other monetary sources such as retirement funds or lines of credit. The recession has made it clear that anything less than a year or two years saved is much too little for a freelancer.
Keep Your Books Clean And Organized
It is very important to be financially organized. If you want to do your taxes by yourself, keep an easy-access spreadsheet of all your expenses, and use accounting software that can create fiscal year and tax statements with a click of a button.
Even if you decide to hire a professional, keep a spreadsheet of all your expenses because electronic records are better than paper records. Plus, you can just email the spreadsheet, and it'll be much easier for them to file your returns.
Filing Folder Method: Use 12-tab folders labeled monthly. Have a travel expense? Record it, then toss it into the month you incurred the expense.
Envelope Method: Use envelopes labeled for each category. Have a meal expense? Record it, then throw the receipt into the "Meals & Entertainment" envelope for the fiscal year.
Don't Forget To Save For Taxes
Being a freelancer also means you don't have your taxes automatically deducted from your paycheck, so you need to save the government's cut on the side.
This tends to trip up a lot of freelancers, because it's hard to get out of the mindset of seeing what is in your business bank account as being freely available to spend. For each project you take on, estimate the taxes you will have to pay (20% is a good rule of thumb), and mentally ignore what is not rightfully yours. (Running your own business has both personal and financial perks. To learn more, check out 10 Tax Benefits For The Self-Employed.)
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Keep A Healthy Cash Flow Buffer
A larger-than-usual cash flow buffer is a must-have for freelancers, because many tend to drain the business bank account without realizing the consequences. Withdraw only what you need, because you never know when you will need the money in a pinch.
You will require money buffers to avoid paying bank charges, to cover the tax amount required for each quarter or at the end of the year, and for incidental expenses or upfront payments without reimbursement.
Business cash flow buffers can vary depending on what industry you are in. If you have employees, or need to buy or hold inventory, figure out how much you need each month, and keep an appropriate amount of cash flow (two months worth, for example) as your buffer.
The Bottom Line
Every financial snag you will run into is an opportunity to learn, and budgeting for an irregular income is no exception. It just takes practice, discipline and good organizational skills. After the first year or two, it will become like second nature.
(To dig deeper into this topic, see Freelance Careers: Look Before You Leap.)