If you expected to earn $120,000, would you want to receive twelve equal, monthly payments of $10,000 or two payments (every six months) for $60,000?
But seriously, try and imagine receiving a $60,000 check today.
What would you do with it?
You’d be king for a while, I’m sure. You might book a vacation or buy a new car.
But, how would you manage the money if you also knew you wouldn’t be paid again for six months, or what if you didn’t know when you’d be paid next?
Big lump sum income, followed by zero income, is familiar to contractors, freelancers and commissioned salespeople. But even those willing to adhere to a budget struggle with managing their irregular income.
I learned my lesson the hard way. Entering real estate at 25 years old, with no experience operating a business including any experience with financial management.
I thought my strategy for money was simple. Just earn more.
I recall looking at a tax return reflecting a big earning year behind me. I was left wondering where the money went, and, how it was possible that I wasn’t just broke, but riddled with debt.
But no matter how much I earned, I was always stressed, always behind.
The cycle kept repeating itself.
Eventually, having backed myself into a corner with debt, I dug deep into learning how to budget and, how to budget with my unreliable income. I’ve finally learned strategies to smooth out my cash flow, eliminating the stress of my financial volatility.
If you have irregular income and struggle to budget because of it, this how-to will show you exactly how to manage irregular income and keep your finances drama-free.
Step One: Ballpark Your Average Annual Income
This step can be tricky. For those earning commission, bonuses, or contract workers, you’ll likely tell me you don’t know what you’ll earn because it’s forever changing. And, I’d agree with you. But, you still need to try and give yourself a REALISTIC estimate of your earning power in the next 12 months. You’re much better working with a super conservative number, rather than a pie-in-the-sky number.
To get started, add up the last three years of your net earnings (what you earned after taxes), then take an average.
As an example:
- 2015 - $60,000
- 2016 - $55,000
- 2017 - $75,000.
Total = $190,000 divided by 3. The rough average is $63,000.
If you’re new to your industry and don’t have income history to work with, ask colleagues to help you estimate potential annual earnings.
Again, avoid using rose-colored glasses so-to-speak. Try and find a conservative, realistic sense of your expected annual net income.
Once you have an average, then, divide it by twelve. Using the example, the monthly net income would be roughly $5,250.
And, yes, I know you won’t receive your income in clean monthly installments - just bear with me.
Step Two: Review or Create Your Budget
Already Have a Budget?
If you have a budget, ensure it’s total (when you add up all categories) is in alignment with or less than your estimated net income above. If your budget total is higher, you might want to consider making adjustments where possible. Otherwise, you’re more likely to start building debt.
Create a Budget if You Don’t Have One
Some believe financial success is possible in the absence of a budget. I wholeheartedly disagree, especially for those of us with irregular income. If you’re looking to finally succeed as an irregular income earner, you must learn to budget.
To get started, make a list of all of your expenses including their costs.
Start with fixed expenses which are those with a fixed amount and a fixed due date. In other words, these are the expenses you know their cost including when you pay them. Examples of fixed expenses might include rent/mortgage, cell phone, internet, and subscriptions.
Next, write down any variable expenses. Variable expenses are those that vary in the amount, and might also vary in when you pay them. Examples of variable expenses might include groceries, gas, clothing, gifts, etc.
While many budgeters would stop here, it’s important to include ‘unexpected expenses,’ which we’ll cover next.
Step Three: Determine Your Monthly Life Expense
While you could add up everything you spend in a given month, you’ll fail to account for the month where your car broke down, or that huge vet bill, or that time you went on that expensive vacation.
You see, many people work through their budget, treating unexpected expenses as complete anomalies - something they find impossible to plan for. While unexpected expenses are unexpected, in most cases, with a little more thought most of us could probably make a few useful assumptions. We could probably estimate their cost, and we could agree that, yes, that thing might happen, but we just don’t know when.
An example. Do you think your car will ever need new tires? Most people would say yes. Do you know when your car will need new tires? Probably not.
Let’s just say that you could estimate new tires to cost $600. In addition to tires, over the course of one year, your car probably needs a few oil changes and maybe some totally bizarre repair. If you estimated (ignoring fuel and insurance), that your ‘car repair’ category might need $1,200 a year, it means saving $100 a month would level out the unexpectedness of an unexpected car repair.
While you don’t know when you’ll face these car repairs, you can bet they’ll happen. Breaking the estimated annual cost into small manageable increments will completely shift your high to dry cash flow problems.
So, your Monthly Life Expense (which is crucial to your irregular income) will include fixed expenses, variables expenses, and a monthly amount for your unexpected annual expenses.
Here are unexpected expenses to include in your budget:
- Vet bills
- Christmas (think gifts, Christmas outfit, extra outings)
- Children Activities
- Income Taxes
Brainstorm any other unexpected expenses that have plagued your finances in the past. Try and estimate how much they might cost you over the course of one year. Then, divide the amounts by 12 to determine an amount you can save each month.
Tip: Consider opening a separate savings account for these unexpected expenses. Doing so will keep the funds away from temptation - leaving them available for when you need them.
Now, add all of your fixed budget categories, your variable budget categories, and your unexpected budget expenses to determine your Monthly Life Expense.
Again, you want to ensure your entire budget amount is equal to or less than your estimate net income from step one.
Step Four: Determine the Length of Your Buffer
Imagine, after adding up your fixed, variable and unexpected expenses that your monthly life expense equals $5,000.
Now, imagine before the end of today, you receive a cheque for $15,000.
Are you rich?
Going to book a hefty vacation?
Even though you receive a bulky cheque, it should be obvious now that a $15,000 cheque will only service three months of your regularly budgeted life.
To smooth the ups and downs of irregular income, you’ll want to choose how many months (using your monthly life expense as the target) you should be able to cover before making unusual spending decisions.
For example, as a commissioned salesperson, imagine receiving some payments totaling $18,000. You might decide to protect three months of earnings, and do something fun with $3,000. Where $18,000 in earnings might’ve felt like a free-for-all before, you should be able to see that to smooth out your income; you need to be able to service the cost of your regular budget (your Monthly Life Expense), before making big purchasing decisions.
And no, I don’t consider this to be an emergency fund. An emergency fund could be seen as similar to saving for your unexpected expenses, although the method described here is much more specific than that.
Being able to cover three months of your ‘Monthly Life Cost’ is a good measure for many people, but you might decide something different depending on your industry and the state of the economy. Having money set in front of yourself allow you plenty of time to correct course if your income slows.
Step Five: Keep a Close Eye on Income Taxes Payable
Many contract workers, commissioned salespeople, and those relying on bonuses, work diligently through the year to save or repay debt, only to be blindsided by income taxes payable.
Keep in touch with your accountant throughout the year to estimate your earnings to date, in addition to potential taxes payable.
The Bottom Line
You can smooth out irregular income by working with a budget, ensuring the budget is less than your estimated net income, and by working to save enough to cover a few months of your budgeted life.
Big spending decisions should only be made when you have months (in the form of income) ahead of yourself.
Where big bulky cheques offer a sense of excitement and temptation - breaking these cheques into monthly chunks makes their impact more realistic while smoothing the highs and lows of commissioned income.