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Budgeting on a self-employed or irregular income



Since I wrote my post about “How to create a zero-based budget,” I’ve had a lot of feedback asking how to budget if you’re self-employed or your income is irregular or unpredicitble. For the most part, the process is the same regardless or how regular or irregular your income streams are. However, there are a few tips that will help take the bumps out of budgeting an unpredictable income and may even make budgeting a pleasant experience.

Overview

  • Use cash for out-of-control categories – Since you may not know when your next paycheck will be, it’s more important than ever to keep a tight grip on variable expenses that tend to get out-of-control.
  • Build up a short-term emergency fund (STEF) equivilant to four weeks of expenses – A STEF will help smooth out the bumps inherent in an irregular income
  • Determine the timing and priority of expenses ahead of time – Planning the order in which expenses must be paid and allocated will relieve a ton of stress. You’ll know exactly where your income needs to go before you even get it.
  • Create a sample budget as a reality check and baseline – A sample budget helps to ensure you are not only living within your means but also achieving your high-level, long-term financial goals.
  • Chunk your income and allocate it once or twice a month – By using your STEF as a shock-absorber for fluctuations in income frequency, you can almost budget like a good-old corporate employee. While you may not envy the corporate lifestyle, a steady paycheck sure makes budgeting easier. By allocating your income in chunks you can budget like a corporate employee while keeping a self-employed lifestyle.
  • Create a “just-in-time” budget, allocating only what you need until the next paycheck – By allocating only what you need until your next paycheck, you’ll be able to squeeze every penny out of each inflow. Don’t allocate your full grocery budget for the month if you only need half of it until your next paycheck.

1. Use cash for out-of-control categories

My first recommendation is to use cash for variable expenses that tend to get out of control. This is crucial for living within your means. You’ll be amazed at how much you can reduce and control your spending just by following this principle. Using cash will give you complete control over the total amount you spend in a given category. When the cash is gone, it’s gone. This is especially important when you need to make the most of each monetary inflow because you may not know when your next inflow will be.

2. Build up a short-term emergency fund (STEF) equivilant to four weeks of expenses

The second step is to build up a short-term emergency fund equivilant to 4 weeks of expenses. This step alone could save you hundreds of dollars in late fees and will give your life a little more peace. It will also keep you from going into debt when an emergency hits. Most importantly for those with an irregular income, a STEF will allow you more flexibility in budgeting and will help compensate for lost income during periods of unemployment or under-employment. For detailed instructions on how to create and manage a STEF, see my previous post.

What if your income varys drastically?

If your income varys drastically, you may want to increase your STEF to 2 or even 3 months of expenses. The more drastic the fluctuations the more of an emergency fund you’ll need. The goal with the emergency cushion is to store up funds in times of plenty to compensate for the times of scarcity. Start with a STEF of 4 weeks and adjust up as needed. However, don’t adjust down. A STEF should be a minimum of 4 weeks of expenses.

3. Create a “Timing of Expenses” list

A “timing of expenses” list simply shows all your bills and when you have to pay them. This will help in our next step to prioritize the order in which expenses should be paid. It will also act as a reference to help ensure you pay your bills on time. To avoid late fees, make sure all your bills are on auto-pay. If auto-pay is not available, highlight the bill so you’ll always remember to pay it on time. As you write your bills down, note on each item if the payment day changes from month to month. There are three main scenarios:

  • Paid on the same day each month (e.g. on the 15th of every month)
  • Paid every x number of weeks (e.g. paid every other Tuesday)
  • Paid every x number of days (e.g. paid every 30 days).

Once you create this list, updating it every month should only take a minute. After a few months you should be able to predict within a day or two when each expense will occur.

4. Create a “Priority of Expenses” list

Note: The “priority of expenses” list and the “timing of expenses” list can be combined depending on personal preference.

When living on an irregular income, it’s important to have clarity ahead of time about exactly where your income will go when you’re paid. Having a pre-determined plan combined with a STEF will help you sleep well at night and decrease the feelings of impending doom and uncertainty that you won’t be able to pay the bills. The “priority of expenses” list is the main tool in helping you decide ahead of time where your income will go. It is essentially a budget arranged chronologically and by importance, rather than by grouping similar categories. You will refer to this list every time you are paid in order to determine where the money goes.

First, list out all your bills in chronological order

List all your bills in chronological order. This will show you the hard landscape that your other categories have to fit around.

Next, list out the rest of your remaining budget categories in order of importance

For most, this list will probably start with necessities like grocery and clothing, followed by high-priority items like savings (STEF, retirement, long-term savings) and debt reduction. Of course, housing would also be considered a necessity but is probably listed under “bills”.

As an example, my list might be ordered like this:

  • Bills (in order of date due)
    • Mortgage – 12th
    • Utilities – Every third wednesday
    • Car payment – 23rd
  • Allocations (in order of importance)
    • Grocery
    • Gas
    • Cushion
    • STEF (if needed)
    • Retirement savings
    • Medical
    • Car maintenance
    • Haircut

This is an extremely abreviated list but you get the picture. After the bills, the most important categories are first and the least important, last. In other words, I first need to make sure I eat and can pay for necessary travel. Then I want to make sure I pay myself (retirement savings) and replenish any STEF if needed. Expenses like medical and car maintenance may not be used every month but will accumulate over time. Therefore it usually won’t matter when in the month I assign those allocations. If I happen to be sick early in the month, I could either use medical funds already allocated in previous months or move that expense up on the list for just that month. Finally, I figure I can allocate my haircut last. If I have a bad month, I could go without one entirely.

Your “priority of expenses” list shouldn’t vary much, if at all, from month to month. Include all your budget categories, even if they don’t apply every month. If you have categories that don’t apply in a certain month (like birthdays), just skip it and move to the next category when allocating funds.

5. Create a sample budget as a reality check and baseline

Having an unpredictable income makes it hard to ensure you’re meeting all your financial obligations, not to mention your financial goals. Therefore, it’s important to create a sample budget based on averages to see if you can meet your obligations AND achieve your goals, despite fluctuating income. The sample budget will give you a baseline from which you will vary from month to month based on your actual income. You should update your sample budget whenever you have a significant change in overall income or expenses to ensure you’re still on track with your long-term financial goals.

First, calculate your average income over 6-12 months. Then calculate your typical monthly expenses including contributions to savings and other financial goals (e.g. debt reduction). Enter in budget amounts for a sample month including these income and expense figures.

If you can’t meet all your obligations AND financial goals on your current average income, you’re due for a change. Otherwise you will never get ahead and always be flirting with increased debt. You need to eliminate unecessary expenses or find additional income streams until you can meet all your obligations, necessities, AND savings goals on your average income. In some cases, a dramatic change in lifestyle may be in order.

6. Creating your actual budget – tips and tricks

Now it’s time to create your actual budget. All the steps until now have helped you create a solid set of reference materials to help you make budget decisions. In fact, you’ve basically made all the decisions about your budget already. Now you simply need to adjust the timing of payments and allocations based on when your income is available and how much there is.

Dealing with income

There are two ways to deal with income depending on how frequently you’re paid. If inflows are infrequent – roughly once or twice a month – treat each check individually and allocate it only for the time period until your next check. If inflows are frequent – roughly more than four times a month – group the inflows and allocate them once or twice a month.

Allocate infrequent inflows check by check

If you’re paid once or twice a month, it’s most efficient to allocate each check individually for the time period until your next check. Let’s look at an example. Let’s assume you are paid $2,000 on the first of the month and you anticipate you’ll be paid again in ten days. Refer to your “priority of expenses” list, determine which bills are due in the next ten days, and allocate the $2,000 accordingly. If the $2,000 doesn’t cover all your bills, or it doesn’t cover the bills and your necessities (e.g. food) for the next 10 days, use funds from your STEF and allocate it as needed. In this case you would designate the STEF amount used as “income” on your budget.

If the $2,000 covers all your bills and necessities for 10 days, continue on down your “priority of expenses” list allocating until the $2,000 runs out. Remember, after your necessities are allocated, replenishing your STEF should take top priority.

Allocate frequent inflows in chunks

If you recieve inflows more than four times a month, it’s easiest to allocate your income in chunks rather than each inflow individually. If you recieve your income in the form of checks, save them up and deposit them twice a month. If your income is automatically deposited into a bank account, just wait and allocate it all every two weeks. It’s easier to allocate a larger chunk of income twice a month than to constantly be allocating fragmented deposits. With your full STEF in place, you’ll be able to safely deal with income twice a month without worrying about negative bank account balances. The STEF acts as a shock absorber, allowing you to budget almost as though you had a regular income.

Split up single budget categories and allocate them in smaller pieces to create a “just-in-time” budget

Occaisionally you may want to split up a single category, allocating part of it with the current inflow and part with a later inflow. If income is tight, this type of optimization will help you squeeze every penny out of a paycheck. By doing so, you create a “just-in-time” budgeting system, allocating only what you need, when you need it.

For example, Let’s say you have an inflow of $2,000 at the beginning of the month. $1,000 may go to a housing payment, $200 to utilities, and $300 for a car payment leaving you with $500 to allocate. Even though you could fully fund a $300 grocery budget category with the remainder, doing so wouldn’t leave enough for other categories like gas, personal, and cushion. Instead, if you think your next inflow will be in two weeks, just allocate what you think you’ll spend in the next two weeks on each budget category. Instead of allocating the full $300 for grocery, you might be able to get by on $150, leaving you more money to allocate to your other important categories and making it less likely you’ll need to dip into your STEF.

Allocate bills/obligations first, then everything else

Every time you allocate money for a period, follow the “priority of expenses” list, first allocating your bills and obligations and then allocating the rest to your other expense categories according to priority. Your allocations may vary from month to month but having the “priority of expenses” list should make the process much easier.

What if I make more than average in a month?

If you make more than average in a month you should have already referred to your “priority of expenses” list and funded all your budget categories. With the remaining income you should fully replenish your STEF to prepare for future months when you recieve less than average income. Allocate the rest however you want.

What if I make less than average in a month?

First cover all the expenses you can from your allocated categories. Hopefully you will already have most of your expenses allocated already. If you run out of income to allocate, you can either take money from your STEF or skip the remaining categories if they are optional (like “haricut”). Fortunately, by the time you run out of income to allocate you should be near the end of your list where the categories are less important. Depending on how much your income varies, you may need to dip into the STEF quite a bit. It’s ok, that’s what the STEF is for. In the worst-case scenario, you should be able to cover a whole month of expenses on NO INCOME.

Conclusion

With a little planning and a methodical approach, budgeting on a self-employed or irregular income can be just as easy as budgeting on a regular income. By using the techniques above, you can take much of the variability out of your planning and know ahead of time exactly where your money should go.

Please let me know your comments and questions. Also let me know if there are points that need additional explanation or clarification. Do you have any additional tricks you’ve learned? Please leave a comment and let me know!


Posted in Budget, Budgeting, Budgets, Cash, Emergencies, Finance, Finances, Money, Personal Finance | 22 Comments »

22 Comments to “Budgeting on a self-employed or irregular income”

  1. REALITY BYTES Says:

    I have had the most radical fluctuation in my income for years. It has taught me to be extremely conservative and frugal. DESPITE my natural tendencies. One trick is to guesstimate your income, but input your receipts daily, (into Quicken or like software is ideal). A fluctuating budget requires almost daily attention. You can adjust for the rest of the month accordingly. Also, it turns out that budgeting becomes even harder and even MORE important with a fluctuating income.
    This is a great list of tips. I would only add to it: Constant attention and vigilence!

  2. b.pack Says:

    Thank You! Finally! I have been struggling with a highly irregular income since starting my own business after a lay-off (no time to build a cushion), and recently started reading several personal finance websites like this one, but every tip, plan and bit of advice that I have found so far is geared to those who draw a regular paycheck. I have been keeping an eye open for advice that might benefit my situation.

    I, too, have been forced to become more responsible and attentive than I ever have, and while it hasn’t always been a pleasant process, I am grateful for the lessons I’ve learned that I will carry on as I return to prosperity — and will help future income go even further and do more for me and my family. I’ve learned stuff I wish I’d known years ago.

    Also, I couldn’t agree more to what the previous commenter said: one of the most important things I do is daily recording of all receipts and expenditures.

    If anyone knows of any other websites, blogs or other online resources for the personal finances of the self-employed struggling with a new business that doesn’t quite yet bring in a regular paycheck, I would really like it if you could add to the comments and point me (and others) towards them.

    Thanks!

  3. Tony D. Clark Says:

    Sam – This is an excellent post. The advice and steps you provide can really help anyone working for themselves and struggling with irregular income.

    I’ve been following many of the tips you provide for the past few years, and I can say not only that they work, but that they’ve saved me on a number of occasions.

    Unfortunately regular budgeting for irregular pay is not something folks consider when setting out on their own. Especially when they’ve had a regular paycheck most of their lives. These fairly simple steps can really make that transition to irregular cash flow much more manageable.

    Great stuff!

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    Thanks for all you information that you have provided. This is fantastic! This is a timely post for me. I’m glad I came across it today.

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  14. Jodi Says:

    I know this is an older post but I was just browsing through some of your stuff and thought I would comment. Our income tends to fluctuate although it is usually that we make less in a month than necessary (we don’t have the up months). The way I have dealt with this is to have my income allocated for one month in advance. Whatever money we earn in May will pay June’s bills. So at the start of June you know EXACTLY how much money you have for the month and can allocate accordingly as Sam mentioned. If you have too many “necessary” categories this also gives you a month or two of leeway to find ways to earn some extra cash. For example, this month I sold some old textbooks, did some online surveys, and picked up a little bit of website design work. This added up to about $200 which was exactly the shortfall we had in our budgeted money for July. We have already cut out so many unnecessary expenses that it is pretty hard for us to trim even more when we have a slow month.

    We also tend to keep around extra money like tax refunds instead of spending it right away. It feels sinful to tap into emergency fund money (even STEF) but if I have extra tax money sitting around unallocated I don’t feel as bad dipping into that if we have a slow month or want to splurge on a little something outside of the budget.

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