Have you ever tried to bake a cake without a list of ingredients? Would be pretty difficult to end up with something edible right? Whether you’re baking, building or putting together a financial plan, it’s important to have a clear understanding of what your inputs are. When planning and investing it’s important to understand how much money you have today, and how much you might earn in the future. Quite often this isn’t a simple question to answer. Many of us have some sort of variable component to our income, usually in the form of tips, commissions, or bonuses. This variability can make it more difficult to put a plan in place, however it’s not impossible. Here I’ll explore a few issues to consider when planning and investing around variable income.
Determine your Baseline Income
If a significant portion of your income comes from variable sources like commissions or bonus, then it’s a good idea to start with a baseline amount. This might be a salary portion of your income, or perhaps it’s just the low end of a potential range of pay. Building your lifestyle around this base level of pay is a conservative way to make sure you’re living within your means. If you’re able to pay all your bills and accrue some savings with just your baseline income, then you’ll set yourself up to spend any extra money on more fun things or save for bigger goals.
Fund your Emergency Savings
Everyone should have some sort of emergency savings. A general rule of thumb is six months of expenses, or non-discretionary income. Emergency savings should be held in a savings or checking account for easy access. The idea is you have some pad available if you fall on hard times, have an unexpected large expense, or to pay bills while unemployed. If your income is irregular it’s even more important to make sure you have money set aside in the event your bonus or commission dries up over some period of time.
Projecting your Income Range
Once you have a comfortable emergency fund set aside you can start to move on to planning for other short and long-term goals. A good exercise would be to project your income range. This allows you to expand over your baseline income. What does your income look like if you have an average year of sales? What if you earn half of your bonus? What if a global pandemic totally changes your industry? What if you do well and exceed your goals or receive a promotion? Planning for a range of possible outcomes will help you to be prepared for anything – good or bad.
Define and Prioritize your Goals
Take time to define and document your financial goals. You probably have short-term goals and longer-term goals to consider. Short-term goals might be a big purchase like a home, car or travel expense. Maybe you have debt you want to pay down. Over the long-term you might want to save for kids’ college, fund your retirement, or pay for a wedding. Once you’ve defined your goals you can prioritize how you’ll fund them. When we help TAAG clients to plan, we often separate goals into Needs Wants and Wishes. The idea being that you shouldn’t fund a Want or a Wish until your needs are financially secure.
Plan your Savings
As additional income from your bonus or commissions is earned, you can put a plan in place to fund the goals you identified. There are a few ways to do this.
The % Method – determine a % of the extra income to apply to each of your goals. As the money comes in you can apply the money to that goal directly, or set it aside for the future. For example, maybe 50% of your commission each month goes into an investment account for long-term growth, another 25% goes to pay down debt, and the remaining 25% is saved in cash for a vacation or a new car.
Fill the Bucket Method – if your commissions are paid weekly or monthly it may be cumbersome to allocate a % of each check. In this case you can do what I’ll call “fill the bucket”. Move the amount of income above your baseline to a separate account and set a target amount. Once you reach the target distribute the money to fund various goals.
Check the Box Method – this method may work if you have a clear prioritization of goals. Essentially you can put all your variable income toward a single goal until you meet it. Maybe you want to max your retirement savings for the year before you move on to saving for vacation, or something else more fun.
Of course, every situation is unique. The key is that you have a plan, some way to monitor your progress and the discipline to stick to it. If you’re able to do that much you will greatly increase the chances that you are successful in reaching all your goals. At TAAG we are available to help along the way – whether its defining and setting goals, putting a plan into action, or helping to monitor your progress.