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How to budget with a variable income

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According to the 50/20/30 rule, non-essential expenses should make up no more than 30% of your after-tax income.

1. Understand your income

The first step in creating your budget is to determine your average monthly income. To do this, you need to be tracking your income and expenses on a monthly basis. If you are paid on a W-2 paycheck, you should be able to get this information from your pay stub or payroll department. If you're self-employed, you should be tracking both income and expenses so you (or your accountant) can pay estimated taxes and file your annual tax return.

Since your income varies from month to month, there are two things you need to get clear on:

  • Your average monthly income, which you can calculate by adding up your net income (your income after both taxes and any business expenses, if applicable) for the past 12 months and dividing that number by 12.
  • Your lowest earning month, which would be your net income for that particular month (again, after subtracting out all taxes and business expenses).

Comparing these two will help you understand how much your income varies month-to-month.

2. Calculate your essential and recurring expenses

Once you have a good idea of how much you earn, the next step is to calculate the bare minimum you need to cover your essential daily living expenses. This will serve as the starting point for your budget.

Look through the last few months of bank and credit card statements to get an idea of the essential items you spend money on, such as:

  • Housing.
  • Utilities.
  • Food.
  • Medical care.
  • Transportation.
  • Debt minimum payments.

The amount of these expenses might vary from month to month, so you'll need to add up the total you spent over six to 12 months and then divide by the number of months to get your monthly average.

According to the 50/20/30 budgeting rule,1 no more than 50% of your after-tax income should go toward essential expenses. Since your income fluctuates, aim for a 50% average after-tax income. Also keep in mind that your essentials represent the leanest budget you can live on, even if that means temporarily cutting other recurring and discretionary expenses (more on that below).

If your essential expenses are more than half of your average monthly income, start exploring options for increasing your income, whether that's by upping your hours, taking on extra clients, or adding a side gig.

3. Calculate your discretionary spending

Next, determine how much you spend on other fixed, recurring expenses that may not be essential, but nonetheless need to be paid each month. That includes expenses such as personal internet, cell phone, gym membership, and subscriptions like Netflix or Hulu. You likely also spend money on non-recurring, non-essential expenses such as entertainment, personal care, clothing, vacations, and gifts.

Some of these non-essential line items, known as discretionary spending, ebb and flow over time. That means you'll need to total up your spending for the past year and divide each category by 12 to get your monthly average and work these into your budget.

According to the 50/20/30 rule, non-essential expenses should make up no more than 30% of your after-tax income. If your average monthly discretionary spending exceeds 30% of your average monthly income, it's a good idea to cut back in certain areas until your income increases or you've managed to save up for them.

4. Don't forget about savings & debt payment

Your expenses should not be the only items in your budget: savings should be treated just like any other bill. Ideally, at least 20% of your budget should be dedicated to saving money.

Your first priority should be to build an emergency fund to protect you in case you have a few low-income months in a row and your reserve funds don't cut it. That way, if you do come up short, you can tap into emergency savings and not have to rely on credit cards or other debt to get by. Start with a goal of saving up an emergency fund of $1,000, then working your way up to three to six months' worth of expenses.

It's also important to save for your retirement, even if you don't have a traditional 401(k) through an employer. Experts recommend setting aside 15% of your income2 toward retirement, if possible. Keep your money in a tax-advantaged retirement account such as an IRA. If you want to save more than the annual IRS cap for tax-advantaged IRAs, consider these other tax-advantaged retirement plans for self-employed people.3

If you have high-interest consumer debt, consider putting some of your savings every month toward paying down that debt, rather than just making the minimum monthly payment. You should also consider cutting down your discretionary spending so you can use that money to help pay off existing debt.

If you're debt-free (congratulations!) and on track for retirement, you have a great opportunity to increase savings for your child's education, a down payment on a house, or other major financial goal.

5. Open bank accounts

Now that you know how much money you spend and earn on average, it's time to set up the appropriate bank accounts to manage your funds.

Reserve fund: Any time you receive income, it should go into your reserve fund. You'll then "pay" yourself on a regular schedule by transferring money from your reserve fund to your checking account. You can pay yourself monthly, bi-weekly, weekly — whatever works for you. Your "paycheck" should be at least equal to your total average essential living expenses plus your fixed discretionary spending for the time period, perhaps a bit more so you have some flexibility in your spending.

The balance of your reserve fund will rise and fall as you have higher and lower earning months, and you'll be able to see how much buffer you have between immediate expenses and reserve funds at any given time. For example, say you earn $5,000 in Month 1 and your expenses total $4,000. Your reserve fund will have $1,000 left over. You earn $6,000 in Month 2, and have the same $4,000 in expenses. That leaves you with an even greater buffer of $3,000 for the next month. In Month 3, you only earn $2,000, which means you can rely on your buffer to help cover that month's bills and still have $1,000 left in the bank.

A good place to keep your reserve fund is a money market account, which is a type of savings account that also offers debit and check-writing capabilities, as well as potentially higher interest rates on higher balances. Consider opening one up with the same bank where you have your checking account. That way, you can get a quick snapshot of all your finances — plus, transfers between accounts will be instant, and you'll likely save money on fees too.

Sinking fund: How do you handle discretionary spending like travel and gifts? After all, these expenses don't come up every month, so it might not make sense to include them in your paycheck. This is where a sinking fund4 comes in handy. A sinking fund refers to a special savings account set aside for irregular, planned expenses such as new clothing or furniture, vacations, or holiday gifts. Instead of including these budget items in your regular paycheck, take the monthly average you budgeted for non-recurring discretionary spending and transfer it from your reserve fund to your sinking fund. You can then draw from this account as needed.

Emergency fund: You should also keep your emergency savings out of sight and out of mind in an account separate from your reserve fund. That way, it's less tempting to spend the money. Plus, since you will rarely touch these savings, you can keep them in a high-yield savings account to help your money grow a bit faster.

Business checking: If you are a small business owner, you'll need to keep your personal and business spending separate for accounting and tax purposes. It's helpful to open a separate business checking account to manage your business income that's used to pay related expenses so it's not intermingled with your personal budget. Then you can put money in your reserve fund from this account.

Of course, life can get a bit messy and the numbers might not work out perfectly every month. Be diligent about spending less during your lower earning months and setting aside extra savings during your higher earning months. With practice, you should develop a system that works for you.

This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.

  1. Paula Pant, "The 50/ 20/ 30 Rule of Thumb for Budgeting," The Balance, Published April 4, 2020, Accessed May 13, 2020. Back
  2. "How much should I save for retirement," Fidelity, Published December 12, 2019, Accessed May 13, 2020. Back
  3. IRS.gov, "Retirement Plans for Self-Employed People," updated January 9, 2020, accessed May 14, 2020. Back
  4. Casey Bond, "What Is A Sinking Fund — And Why Should You Have One?," HuffPost, Published February 20, 2020 , Accessed May 6, 2020. Back