How Do I Plan Financially When My Paychecks Are Inconsistent?

Welcome to Taking Stock, a space where we can take a deep breath and try to figure out what the COVID-19 economy really means for our finances. Every month, personal finance expert Paco de Leon will answer your most difficult, emotionally charged questions about money. This last two years have forced many of us to reprioritize our finances, and there’s no clear road map for getting through the pandemic yet — but Taking Stock is here to help us figure it out together.
This month, we're talking about what it's like to feel financially secure as a self-employed freelancer with sporadic paychecks. How do you manage your money to ensure you have a safety net when your pay schedule is inconsistent?
If you'd like to share your own experience (good or bad) with managing money as a freelancer, we'd love to hear from you.
Dear Paco,
My husband and I are both TV writers. We get paid in lump sums, so when money is coming in, we feel rich. But we have long stretches between paychecks, and the last stretch has been really long. Since the pandemic, work has been so slow, and my savings are on their last gasp. My partner and I have been working for over 10 years, so our past income wasn't a fluke, but even in those years of consistent income, there were scary dips where suddenly a project didn't go through and we were broke again.
I feel like I still spend normally for my kids, but I spend nothing on myself — no indulgences. Cheaper groceries, no dining out, no new clothes. When we’re using our savings we feel okay, but my savings aren't savings so much as the “salary” I'm going to use in the gaps between checks. Part of the quandary is living and working in an industry where a lot of folks are very rich and others are just squeaking by, so getting a tab on where we actually are in the spectrum of things is weird.
Right now, though, we’re broke. My partner and I are both currently unemployed and feeling desperate — frogs getting cooked in the "something's gotta give, right?" water. My question is, as freelancers, how do we know what we can afford when we get paid in these lump sums that come irregularly, with no guarantee of coming again? If/when we get paid again, how do we protect ourselves? I have no idea how to financially plan as a freelancer with potential for big checks or no money ever again. I want to know how to have secure income, how to set up side income streams, and how to save and plan for money the next time it shows up.
Dear feast or famine freelancers,
Congratulations on a decade of success in a very fickle business. So many people dream of the professional reality you’re living. Even though you’ve become freelancers more out of default than choice, there are benefits to being self-employed, like being able to leverage the tax code in ways employees at companies can’t. 
That said, you’ve been managing your income more like an employee than an employer. Instead, you need to create some processes and procedures to manage your income like the business that it is. Doing this will give you the clarity you’re seeking, and once you have more clarity, you can start to explore additional revenue streams or give your current one a real evaluation based on your numbers.
One of the most effective ways to manage your lumpy cash flow is to simulate being paid a regular paycheck from the lump sum. Think of it like this: Every dollar you earn will get portioned out. You’ll save a portion for income or self-employment taxes. You’ll use a portion for business expenses (overhead). And a portion will be used to pay yourself. 
To execute this strategy, you need to keep your business and personal finances separate. You need to know what your business expenses are each month, and how much and often to pay yourself. Before we dig into all of that, let’s talk about a very important step in getting organized.

Schedule weekly finance time

The first thing every self-employed person needs to do is set aside 30 to 60 minutes each week to manage their finances. I suggest blocking out the same time every week as a recurring event. I’m asking for a lot, but it’s important to understand that when you work for yourself, you’re running a little business. The business requires attention, care, and focus. And when you give your business these things, you might be shocked at how much better you’ll feel about your finances. You may also find that you’re less stressed throughout the week because you know you’ve set aside time to deal with your finances.

Set up separate business accounts

Every self-employed person needs to separate their business and personal finances. Whether or not you have a formal business entity, like a limited liability company (LLC), a corporation (like an S-corp), or you are a sole proprietor (the default type of business for folks who don't actively form a company), it’s a good idea to set up a business checking account that is separate from your personal checking account. You’ll also want to set up a business savings account where you park your savings for income taxes. 
You can go to the bank (or choose an online bank) to open up new checking and savings accounts. If you have a formal business entity, these will legally be business accounts. If you are a sole proprietor, the default type of business, you can just open up two new personal accounts. We will use our robust and vivid imaginations to allow ourselves to believe these accounts are formal business accounts.

Figure out how much you need pay yourself each month

Creating structure around how much you’re paying yourself can help you ration your lump sum payments. It can also help you understand how much you truly need in leaner months so you can make that adjustment. 
Figure out what you need to pay yourself each month by looking at these three very broad categories:
The bills and life category: How much do you need for your monthly essential living expenses?
The fun + B.S. category: How much do you want for non-essentials each month?
The future and goals category: How much can you reasonably afford to save/invest every month? (Hint: General financial wisdom says to save/invest 10% to 30% of what you earn. For self-employed folks, you might have to work backward and play with some numbers to figure this out.)
The monthly total of these three categories is how much you would pay yourself. You calculate each total by reviewing the last three months of your spending. Some of these costs will be fixed, like rent. For other costs, you can calculate an average monthly cost over the last three months. Alternatively, you can take a maximalist approach and base your monthly spending on the largest amount you spent over the last three months. 
For example, in June you spent $800 on groceries, in July you spent $885 on groceries, and in August you spent $815. The average spend is $833 because $800 + $885 + $815 / 3 months = $833. But the most you spent is $885. So you could choose to allocate the average, $883, or the most you spent, $885.
Take your time to work out different scenarios. If you’re having a hard time understanding how to think about this, I’ve done a lot of writing about spending plans — both how to create them and manage them — and I don’t want to get too into the weeds here, so please, dig in here or check out chapters two and three in my book, Finance for the People

Figure out how much your business needs each month

You can figure out how much you need for business expenses each month using the same method from the prior section to calculate your overhead. How much did your business spend over the last three months on business expenses? Decide if you want to use an average or choose to allocate the maximum amount you spent over the last three months.
Examples of some business expenses you might have are coffee or lunch expenses for meetings, the cost of a website if you have one, and the costs to pay another writer to write some jokes. 
Typically, writers have low business-operating expenses compared to other types of businesses. But there are also a lot of opportunities to write off expenses that you might not be aware of. Talk to your accountant about expenses you might be paying out of your personal accounts that you should shift to your business.

Keep your business and personal finances separate

Once you have separate accounts, you should get into the habit of keeping your business and personal finances separate. Whenever you get paid as a freelancer, that money should go into your business checking account. 
Use your business account for business expenses. Do not pay for personal expenses from your business account. For personal expenses, you’ll pay yourself, which I’ll get to soon. 
When you file your taxes at the end of the year, it’s helpful to have your business expenses already separate from your personal expenses. This will save you time, money, and precious, precious sanity.
Once you know how much you need to pay yourself, plus how much your business spends each month, you can better conceptualize how many months each lump sum payment will last. Now let’s factor in taxes.

Get into the habit of saving for (income and/or self-employment) taxes

There are many methods for figuring out how to save for income and/or self-employment taxes. The following method is by far the quickest and simplest. Although I know enough to be dangerous to myself and others, I am not an accountant, and this is not tax advice. Ask your accountant to look at your unique tax situation and advise you on how much you should be setting aside, because they might ask you to use a different method for tax savings than what I lay out here.
Here’s the quick-and-dirty method: Every time your business gets income, save a portion of the income for taxes. Simply transfer funds from your business checking account to your tax savings account. In general, you’ll save a percentage of every dollar you earn. The general rule of thumb is to save no less than 10% and up to 30% of every dollar you earn. 
After you save for taxes, the money left in your business account is what you’ll use to pay yourself and your business expenses each month and pay for your business expenses. 

Pay yourself a paycheck based on what you need each month

Once you figure out how much you need to pay yourself, start paying yourself each month. You can pay yourself weekly, biweekly, or monthly; it’s up to you.
Most self-employed folks will pay themselves by making a bank transfer from their business to personal checking. The caveat is that if you have an S-corp, you’ll need to run payroll at least once a year, but your accountant can help you with that. Just do me a favor: Don’t mistake this for tax advice. Go get that sweet, sweet tax counsel from your accountant.
Paying yourself will create the illusion of consistency and forced scarcity, which in your case is a good thing. It might also feel like the hot morning sun hitting your face after a night of too many margaritas — a harsh wake-up call that you need to earn more. The good thing about this is that now you have that clarity.
A note to the reader: Paying yourself a fixed income works really well for a business that doesn't have a lot of overhead. For other business types, this might not be the right approach; it might make more sense to pay yourself a percentage of what the business earns.

Have a personal emergency fund 

Your personal emergency fund is your first priority because it'll be your first line of defense in the event of a financial shock, or during a period where you have no payments coming in. Your fund should be saved in liquid assets (cash) that you can access quickly, without penalty.
General financial wisdom says you should save three to 12 months of expenses in your emergency fund. These are guidelines based on generalized risk. You can choose how much you want to save based on your personal comfort. For some, saving six months is plenty, while others might require 12 months of reserve to sleep soundly. 

Know your runway

If you’ve figured out how much you need to pay yourself and how much your business spends each month, you should be able to have a good estimate of how long your runway is. 
For example, let’s say you pay yourself $7,500 a month and your business needs $1,000 a month; that’s a total of $8,500 a month. And in your business checking account, you have $27,000, and you’ve already saved for taxes. You have a little over three months of runway in your account because $27,000 / $8,500 = 3.176.
Knowing your runway will give you even more clarity. It might bring to light that you’re not earning as much as you need, or it might show you that you’ve just been unorganized. Either way, thinking like this can help you think more strategically, which is valuable if you decide to create other businesses and revenue streams. 

Invest and explore other revenue streams

Before you start taking more risks with your money, first get a grip on how to manage your freelance income. Once you have a handle on managing your income, explore your options and get educated on how to invest through retirement accounts, brokerage accounts, and potentially even through other types of businesses. 
Even though you’re in an industry where you don’t have much control and you’re subject to the decisions of other folks, doing everything I’ve outlined above is a way for you to create a sense of control in the face of uncertainty. Of course, there are plenty of other non-financial practices, from breath work to talk therapy, that you can seek out to help you deal with our inherently uncertain human experience. 
Your friend,

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