Manage Your Variable Income With the Paycheck Percentage Rule

Written by on January 9, 2017

Learning how to manage your variable income is one of the biggest challenges freelancers face. Whether you cobble together an income from a series of smaller projects or rely on anchor clients that send you different amounts of work each month, reliably predicting freelance income is tough; yet, it’s critical to understand your income, expenses and general targets.

Crafting a budget is an imperfect process, even when you collect the same paycheck every week. Adding variable income to the mix just makes things more interesting. In my own business life, I’ve found that applying a simple, percentage-based system to each payment I receive is the easiest and most consistent way to manage my money.

The Percentage-Based Rule

Any financial exercise should start with understanding your baseline. In this case, your baseline is your monthly expenses: your rent or mortgage, utilities, food, telecommunications, business expenses and anything else hitting your bottom line. While your income may be variable, chances are many of your expenses are actually fixed. Take a closer look at your spending during a three-to-six month period, and come up with a realistic projection of what you spend.

Frontline Planning for Taxes

For many freelancers, taxes are a complicated and frustrating area to consider. Regular employees simply have taxes deducted from each paycheck and then file their taxes at the end of the year to make sure the numbers line up. They often get a refund, too. If there’s an unexpected bonus or other income, a regular employee might owe a little to the federal or state government, but it’s rarely catastrophic. Freelancers, however, are responsible for paying their own taxes. Without a clear system in place, things can quickly spiral out of control.

The best strategy is proactive. Do your best to estimate your income for the year. Use last year’s income plus whatever business intelligence you’ve gathered this year to determine what you think you’ll make. Then, understand the percentage of your paycheck you need to allocate to:

  • Federal taxes
  • State taxes (if applicable)
  • Local/city taxes (if applicable)
  • Self-employment taxes

Add up these four tax categories, and you’ll arrive at a percentage of your income that’s paid to Uncle Sam each year. It will vary based on your bigger financial picture, family situation, income level and deductions. You should set aside whatever the magic number is for you (32 percent, for example) for each and every payment you receive.

Whether it’s a $50 honorarium or a $10,000 mega-project, shave your tax percentage off the top and put it into its own bank account. Use those funds to make quarterly or annual tax payments, as required. You may also want to check with an accountant at the beginning of the year to make sure you’re on the right track and avoid any expensive surprises at the end of the year.

Breaking Down Your Post-Tax Income

Once you’ve calculated your post-tax income, you’ll know what’s left. From there, think about your overall expenses. For example, you’re on target to bring in roughly $5,000 each month, and you know you generally receive about 10 payments per month. Let’s assume your rent is $1,000 — that means 20 percent of each payment you receive is allocated to rent.

Depending on your expenses and financial cushion, you may want to do this for individual expenses, or you can use a lump sum “cost of living” approach. I do the latter, because it’s easier for me. I simply transfer any excess (if that happens!) to my emergency savings or retirement fund.

Having Fun, Sinking Funds and Planning for the Future

Finally, we’ve gotten to the best part of your income: what’s left over after you’ve paid your taxes and bills. For the sake of argument, we’ll assume it’s 30 percent of your total income. How do you want to spend that 30 percent? Think about your short-term goals, like taking a trip to the Caribbean; medium-term goals, like buying a new car; and long-term goals, like eventually retiring. You can then break down allocations to the following categories:

  • Retirement: What are you putting away for the future? Planning for retirement gives you a sense of control, even if you’re just putting aside 1 or 2 percent of your income. Aim for 15 percent (or the max allowed by your retirement vehicle), if possible.
  • Sinking funds: Start saving in advance for planned purchases, including vacations, appliances, medical bills and more.
  • Fun money: You can allocate fun money any way you want, including movies with friends, impulse purchases and the like. You don’t have to allocate this down to the dollar — just know what falls into this category and what’s already covered elsewhere in your plan.

Making It All Work

Ultimately, it’s a zero-based budget, which ensures that every dollar you make each month has a clear purpose. Some people use multiple bank accounts, while others use a cash-based system for everything they can, and actually use a wallet designed to put money for groceries, bills and entertainment into different categories. You can also use the percentages as a general guideline and do regular check-ins to make sure the overall plan stays on track.

A percentage-based approach is flexible enough to scale or contract with your business, as well as keep you focused on the right categories. Learning how to manage your variable income successfully ensures your freelance business remains sustainable over the long-term.

Leave a Reply