Most people are fortunate enough to receive regular, steady income. They know exactly what each paycheck will be based on a consistent hourly wage or salary. Others live on what is called ‘variable’ income. Some work solely on commission while others are self-employed.
Trying to make a go of it on variable income can be complicated. Not knowing how much income you will have coming in every month makes it hard to count on anything financially. If you are in such a position, this post is for you. It will address some of the biggest challenges of variable income and how to overcome them.
As you read, keep in mind this statistic from Pew Research: 16 million Americans were self-employed last year – roughly 10% of all working adults. The self-employed represent one of the largest blocks of workers whose income is variable.
Challenge 1: Budgeting
Budgeting is a monumental challenge when you are living on a variable income. Why? Because it requires knowing exactly what you have coming in and going out. Variable income is fluctuating income. You overcome this reality with a multi-step process.
The first step is to assess all of your known monthly expenses. Write them down, add them up, and come up with a total. This is the minimum amount you need to pay your bills. Some months you might make less while other months you make more.
The second step is to average your income over the last six months to see how it compares to your monthly budget. This will tell you how you are doing in the grand scheme of things. If your monthly average is less than what your budget will support, you need to increase your income.
The third step is to set up a savings account. Any months in which you earn more than you need to maintain your budget, put the excess in the savings account. It will be there during those months when you do not make enough to pay the bills.
Challenge 2: Planning for Major Expenses
Hand-in-hand with budgeting is planning for major expenses. Perhaps you and your family have always wanted to take a trip to Europe. That is going to cost quite a bit. With a steady and reliable income, you can plan to set aside so much every month until you have enough to travel. That means you can also set a target date. It is not so easy when your income varies.
Overcoming this challenge is all about looking at the big picture rather than individual paychecks. Assuming you have been dealing with variable income for several years, average out what you make annually. Then divide that by 12 to come up with an average monthly amount. This amount is the baseline from which you can start planning. Your numbers may not be accurate down to the penny, but you should be close enough to still develop a reasonable plan for monthly saving and meeting your target date.
You can use the same system for saving to replace your car, remodeling your home, setting aside money for the kid’s college funds, and so forth. The only real difference between variable and steady income in this regard is that you are working with averages rather than hard numbers. Averages work fine if your data set is large enough.
Challenge 3: Saving for Retirement
People with steady paychecks find it easier to invest for retirement by having a certain amount from each paycheck put into a retirement plan. Those living on variable income may find this a bit more challenging because they are not able to make regular contributions. You can overcome this challenge by saving for retirement in an IRA rather than a 401(k).
An IRA is an individual retirement account. It does not require regularly scheduled contributions. You can contribute whenever you have the money. You set up an IRA and then make your contribution as part of your monthly budget. During the lean months you can delay the contribution. You make up the difference during the good months.
Another great thing about IRAs is that there are nine different types. The two most common are traditional and Roth IRAs. A traditional IRA is ideally designed for workers who do not have access to employer-sponsored retirement plans. All contributions made to a traditional IRA are tax deductible the year they are earned. However, retirement withdrawals are taxed.
The Roth IRA is nearly identical to the traditional IRA with one exception: taxation occurs on the front end rather than the back end. In other words, contributions to a Roth IRA are not tax deductible. But withdrawals during retirement are not taxed. In theory, you should pay less income tax this way.
As someone with variable income, you have access to many different kinds of IRAs. They can be your best friend in preparing for retirement.
Challenge 4: Borrowing
Not having steady, verifiable income can be a nightmare when it comes time to borrow. Banks want a rock-solid paper trail of verifiable income to prove credit worthiness. Without that paper trail, getting a loan can be nearly impossible.
How do you overcome this challenge? By meticulously documenting everything. Let’s say you are self-employed. Make sure you generate invoices for every job. Save copies along with proof that your customers have paid their bills. Also, keep a standard accounting of your business using normal accounting rules.
Next, save your tax returns for a minimum of seven years. Do the same for your bank statements. If you prefer to keep your bank statements online, download digital copies and save them to a flash drive. Between invoices, business accounting records, tax returns and bank statements, you should be able to verify your income easily enough.
Living on a variable income is fairly common these days. Doing so can be challenging from a personal financial management perspective. However, it doesn’t have to be. Follow the advice offered here and you will be off to a good start.