A budget is foundational to successfully managing your financial situation. It functions as a forward-looking map for your spending and saving and a backward-looking monetary trail to track progress and opportunities for improvement. Most people grasp the goal of budgeting, spending less than you earn, but how do you make a budget if your income varies from month to month? Is it possible to design a budget that accommodates this kind of unpredictability?
The answer is yes; it will just look a bit different. The basic concept of spending less than you make still stands. You will still be able to track your spending habits to ensure your spending matches your goals and priorities and adjust accordingly. However, you will need to set an income “number” in order to formulate your budget.
How Do I Pick the Right Income “Number” for Me?
Your personal “income number” refers to the total amount of money you are budgeting for savings and expenses combined. It is vital for your financial success to be conservative in picking your “income number.” To pick an appropriate income number, look at your income over the past 12-24 month or further out if your income has remained steady. Write down this income data or put it in Excel and remove the 2 highest income amounts in each year. Removing the higher totals ensures your estimate will be conservative. Then, find the average of the remaining numbers. This is your estimate of income going forward. It will be lower than your true average income, allowing for more unpredictability or dips in your income.
If your income is irregular, you are likely working as a contractor rather than a W2 employee. Many small business owners fall into this category as well. Contractors and some small-business owners will be responsible for paying 15.3% in “payroll” taxes. In order to avoid large tax bills, make an accurate estimate of your tax liability before tax-time rolls around. Consider your Federal Income Taxes, Payroll Taxes, and State/Local Taxes when planning how much to set aside monthly. Calculate your estimates using a free tax calculator online, or consult your Financial Planner or Accountant for a more in-depth, personalized projection.
Use a Separate “Income Account"
Commonly, those earning an irregular income live like a king in successful months but have no reserves for months with little to no income. They find themselves surviving on Ramen during those months and desperately hoping for a better result next month. One way to avoid these highs and lows is to smooth out your income using separate bank accounts.
Many banks will let you open additional checking or savings accounts with no fees and no minimums. Open an account that you will use as your income account, which will be kept separate from your checking account. Direct all your income to this account. This allows you to set up automatic transfers from your income account to your checking account. These transfers serve as your regular paycheck to yourself and will create consistency within your budget.
Your income account should naturally grow over time because the transfers to your checking account should be the conservative income number we calculated earlier. As your income account grows, set an upper limit for the amount of money you want to leave in it. When you reach that set threshold, it is wise to transfer the excess in your income account into an investment account, giving account, or vacation fund based on your long-term goals.
Managing your own cash-flow can be valuable from a financial planning and wealth building standpoint, but it is also very helpful from a psychological perspective. There is comfort in consistency. If you can mentally forget about the “income” account by separating it from your personal checking, you will feel more consistent in your income and expenses and hopefully avoid any more “Ramen noodle months” in your future.
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