It’s easy to divvy up a paycheck. Freelance income, not so much. The biggest problem with making a spending plan (because we all hate the word budget, right?) is that you’re never sure how much you’re going to get, and when it’s going to show up. This is a huge problem when you’re first starting out, but it’s still an issue even after your established—while you might know your average earnings, you still don’t know exactly when the check will be in the mail.
I’ve long recommended Ramit Sethi’s concept of dividing your income into percentages, rather than amounts. This works whether you get a regular paycheck or intermittent checks from freelancing or a small business. When I work with clients, we focus on constraining fixed expenses, prioritizing different types of savings, and managing discretionary spending. But if you’re a one-or-few person operation, there’s more to consider. I’ve been very happy, recently, to discover Mike Michalowicz’s book Profit First. (Disclaimer: both of these gentlemen sell a lot of products and services. I’d suggest reading their books and being an aware consumer–figure out what’s right for you!)
How much do you need to keep the business running? As a solo, it’s very easy to send nearly all the money to your personal account, then need to loan it back when business bills come in. Even if you don’t have a lot of expensive memberships and licensing requirements (my hand’s up), you’re still going to need to replace computer equipment; update software; print business cards, brochures, etc.; and perhaps pay an accountant or attorney. To this I would add that if you’re truly self-employed, you’re also going to need to factor in the cost of benefits usually supplied by an employer: health, life, and disability insurance; a reasonable amount of paid vacation, sick days, and holidays; contributions to a retirement plan; and the space you need to work. Michalowicz suggests that these operating expenses should be no more than 30%. I might quibble with that a little if we include health insurance, and I’ve been hard pressed to keep them under 35% myself, but it’s a good general principle.
The next big bugbear after keeping the doors open is keeping the wolf (aka, the IRS) away from them. Rather than scrambling to come up with the quarterly payment two days before the end of each quarter, Michalowicz suggests putting 15% of every check in a (preferably inconveniently located) savings account. This actually seems a little high to me, particularly for a start-up where you may not have all that much taxable income, but it depends on how the business is organized, and what you’ve paid in the past. In any case, I’d suggest no less than 10% of each payment/check go to tax savings. If you don’t need it all, there’s always next year (or property taxes).
When do you pay yourself? Okay—next up, owner’s pay. Here, Michalowicz suggests you pay yourself 50% of the gross. This is the amount that I would consider available to apply Sethi’s budget percentages, although where the retirement savings comes from depends on your own business model—just be sure it comes from somewhere!
Finally, Michalowicz points out that it’s absolutely essential to set aside something—5% suggested—for profit. As he rightly points out, without siphoning off some amount, you’ll have nothing to show for your work. Although he suggests using this money to ultimately reward yourself for hard work, I’d be conservative and say this is your business emergency fund until you have enough to keep up with expenses for 3-6 months, tiding you over any cash flow crises or dry spells.
Try out the percentage system. Using specific dollar amounts, and not meeting them at times, makes you feel like a failure and a spendthrift. When you use percentages, you’re always a success.