How to Level out Roller Coaster Income

This is meant to serve those who have a volatile income - the self-employed (commissioned employees and people working on contract) - while those with more regular income (salaried or hourly wage earners) might find this helpful too. 

If you had the choice, would you rather receive $10,000 per month for one year, or $60,000 twice per year?  For most of us, receiving a steady and predictable monthly income will have better results than lump sum payments.  For whatever reason, receiving $60,000 twice a year can feel like more money than a monthly offering of $10,000.  Below is a step-by-step guide for managing unpredictable cash flow resulting in less stress, and more restful nights!

I want to clarify in advance, that I am not an accountant or bookkeeper.  I am sharing how I estimate and manage my earnings, taxes, etc. to make life easier.  Of course, some situations are much more complex and may need the help of an accountant.  I still think the information provided below is a really helpful guideline to make your life simpler.

One more thing: this post is not for those who are incorporated and dealing with corporate taxes, although, it might still be helpful.  The tax calculator suggested is for personal tax and does not consider those incorporated.

Here’s what you need to know to get started:

  • what you plan to earn this year (yeah I know, for some who earn commission income, or who work on contract, 'knowing' what you'll earn is next to impossible.
  • And, what you spend each month. (most of us don’t know this either).

 

Step 1: Determining What You’ll Earn this Year

There are two likely scenarios when determining income.  The first are people who have experience (The Experienced) in their field and therefore a track record of earnings behind them.  The second are people new to an industry (Newbies) with no to little track record.  Each scenario is different when determining what you’ll earn this year.

 

For The Experienced Group

Use your previous three years of earnings, and take an average of your gross earnings (how much did you make before taxes and expenses were deducted).  For example, if you earned $100,000 in 2014, $120,000 in 2015, and $80,000 in 2016, add these figures together, and divide by three to develop an average:  in this case, the average is $100,000.

 

For the Newbie Group

If you’re new to an industry, it can be helpful to ask a manager or a mentor what you can expect to earn in the first year when you’re new.  There will always be exceptions, but it’s important to have an estimate to work with.  Try and ask questions of those who are more experienced to get a sense of where you stand.  For our example, let’s assume, you’ll earn the same amount ($100,000) as the Experienced Group – the point of this isn’t how much or how little the money – the principles that follow are the same no matter the amount.

 

Step 2: Determine Who Collects the Income Tax

Next, you need to know what happens to income tax when you get paid.  This can be the single largest financial destroyer if ignored at any time in the year – but especially early in the year.  You need to know if you collect all of your income, including income tax and/or GST (in which case, some of the money in your bank account doesn’t belong to you) OR, does your employer deduct income tax and remit it on your behalf.  In either case, it’ll still be important to approximate the percentage at which you can shave off income tax.  Even when your employer remits income tax on your behalf, it might not be enough, so best to be aware and plan accordingly.

 

Step 3: Use Online Calculator to Estimate Income Tax

Next, use an online personal income tax calculator to estimate how much tax would be payable.  My go-to site is the Ernst & Young’s Personal Tax Calculator.  Go to their site, and enter the gross income estimated in Step 1.  We’re still using $100,000 for the purpose of the example.

According to the EY 2017 Personal Income Tax Calculator, based on your estimated earnings of $100,000, and without any write-offs, $23,648 will be due to CRA.  This results in $76,352 for you to spend.  Dividing this number (the really rough NET INCOME)  by 12 months results in a monthly income of $6,362.  This also means that every time you collect/receive commission/money, 23.65% of it isn’t yours.   Your business expenses (AKA write-offs) can decrease your tax owing significantly, but to err on the side of caution, it’s best to assume no write offs to get started.

 

Step 4: Set Up Separate Bank Account(s) to Hold Taxes

Setting up separate bank accounts can help with accidental overspending, but also the temptation of spending income tax money while convincing yourself you’ll pay it back later in the year.  Once this money is moved, it should be considered untouchable unless you’re cutting a cheque to CRA, or your final income tax bill says you didn’t owe that much.

TIP: Every time you get paid – no matter the amount, take off the income tax percentage (or 23.65% for the sake of our example) and move it into a separate bank account for safe keeping – never to be spent.  So let’s say you get a cheque for $3,000.  $3,000 * 23.65% = $709.50.  So $709.50 should be deducted and moved into your income tax safekeeping account.  However, if you ALSO COLLECT GST/HST, you must remove and separate the GST/HST in addition to the estimated income tax.  In this case, divide the total amount received by the GST/HST amount (in the case of BC, divide the $3,000 received by 1.05 resulting in $2,857.14 (or $142.86 for GST), THEN deduct the estimated income tax amount, so $2,857.14 * 23.65% = $675.71.  This means that one bank account will receive $142.86 of GST, and the other bank account will receive $675.71 of estimated income tax, resulting in $2,181.43 for you.

 

Summary of Bank Accounts after Receiving $3,000 which include both Income Tax and GST:

GST Savings: $142.86

Income Tax Savings: $675.71

For me to Spend ACCOUNT: $2,181.43

Efficiency Tip:  Rather than crunch these calculations each time you get paid, a spreadsheet can expedite this process and reduce errors.  Read my prior blog post about organizing commission and utilize the included pre-made spreadsheet.

 

Step 5: Calculate What you Spend Each Month

You NEED to have a sense of what you spend each month to even out your cash flow.  There are two ways to acquire the information you need.  The first, and more arduous is to comb through bank statements and write out a list of estimated expenses.  Below I will include what to remember when drafting your list.  The second and fastest way is to sign up for a Mint account.  Mint is a free online finance tool.  It will sync with your bank accounts, import transaction history, and show monthly categories totals – all within a few minutes.

You might want to break down business expenses and personal expenses.  Either way, you need a monthly total to work with.

Let’s assume you’ve calculated that you spend $1,500 on business expenses and $4,000 on personal expenses each month.  Essentially, your life costs you $5,500 per month.

 

Step 6:  Set Up a Month Ahead Savings Account

So, when you receive a $10,000 cheque and have removed the GST/HST and the income tax that wasn’t yours, to begin with, you are left with approximately $7,271.43 (after using principles listed in Step 4).  This means that you should deduct your estimated monthly expenditures of $5,500 and push the balance forward for the next month.  So, $1,771.43 should be transferred into another account – which ensures you don’t spend this money.  Then, next month, if you earn less than your monthly expenses of $5,500, you’ll add whatever you receive to the $1,771.43 overage as a top up.  This piece is critical as the ‘lows’ of the income roller coaster will be leveled when you can use the top-up to even things out.  The more money you can push forward, the more you’ll be able to see ahead when things tighten up.  It leaves more time to react.  At some point, you might develop a few months of saved income – set aside in a savings account.  If you face no income now, you’d still have a few months to plan, cut back, and respond.

 

A Common Concern: What should I do if I have money saved for GST/HST, and money saved for income tax, but no money in my chequing account, and bills that need to be paid?  This is a tough question and can be answered only by being truly honest with yourself.  If you consider yourself ‘not-entirely-responsible’ with money, DO NOT touch money saved for GST/HST and/or income tax.  It WILL come back and bite you later.  You are only deferring the pain now.  I would suggest treating the two savings accounts as untouchable, and doing what you would normally do when faced with no income.  You might need to borrow temporarily, and/or cut back until more income rolls in.

 

Step 6: Live on a BUDGET

This is the hardest part of unpredictable cash flow – living on a budget.  Unfortunately, budgets are thought to be boring and restrictive.  Most people equate them to a financial diet of spinach and egg whites, both tasteless and dull.  I can tell you first hand that budgets remove guilt when shopping, provide predictability – in a good way, are empowering, and are (in my humble opinion) THE ONLY WAY to make peace with roller coaster income.  I use YNAB.com (AKA You Need A Budget to manage my money) and I don’t think I could function for one day without it.  It guides all of my decisions and planning.

I’ll write another detailed post on developing a budget (including categories to spoil yourself) but for now, here are a few things to consider when drafting your budget.

Under Personal Expenses:

  • Write out Your Fixed Monthly Expenses.  These might include your mortgage payment, car insurance, strata fees (or home association fees/condo fees), property taxes, cell phone bills, electricity bill, cable, the internet, subscriptions, etc.
  • Write out Variable (or fluctuating) Expenses and how much you expect to spend each month.  These includes groceries, gas, parking fees, entertainment, birthday gifts, Christmas expenses, etc.
  • Write out Fixed Annual Expenses and divide by 12.  This might include property taxes,

 

Repeat Under Business Expenses:

Repeat, using the same three categories listed above, but with your BusinessRelated Expenses in mind.

Finally, I can tell you that having an awareness of your spending is much different and less powerful than shifting spending patterns and making decisions because of your budget.  Again, for those who are interested, I will draft another post on how to budget and why you’ll be able to spoil yourself guilt-free when you use one.

To summarize:

You now know your rough estimated earnings, including how much would be owed to CRA, and how much is left over for you to spend.

You now have, three new bank accounts:

1.  GST/HST Savings Account

2.  Month-Ahead Savings Account

3.  Income Tax Savings Account

And you know how to determine how much from each cheque should be moved into your GST/HST, Income Tax, and Month Ahead accounts to leave your chequing account money free for spending.

You also have a good sense of your monthly spending, including how much you spend in certain categories.

Do you have any other suggestions for managing irregular income?